Article ID Journal Published Year Pages File Type
963135 Journal of International Economics 2009 12 Pages PDF
Abstract
This paper analyzes optimal monetary policy in a small open economy featuring monopolistic competition and nominal rigidities. It shows that the utility-based loss function for this economy can be written as a quadratic expression of domestic inflation, output gap and real exchange rate. The presence of an internal monopolistic distortion and a terms of trade externality drives optimal policy away from domestic inflation targeting and affects the optimal level of exchange rate volatility. When domestic and foreign goods are close substitutes for each other, the optimal policy rule implies lower real exchange rate volatility than a domestic inflation targeting regime. The reverse is true when the elasticity of substitution between goods is low.
Related Topics
Social Sciences and Humanities Economics, Econometrics and Finance Economics and Econometrics
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