Inventories and optimal monetary policy in a small open economy

We study how inventory investment affects the design of optimal monetary policy in a New Keynesian small open economy model. We find that under producer currency pricing, when the intratemporal elasticity of substitution is smaller than 1, optimal monetary policy in our model with inventories is similar to a standard model without inventories. However, when the intratemporal elasticity of substitution is larger than 1, inventory investment increases the importance of nominal exchange rate stabilization relative to a standard model without inventories. The importance of nominal exchange rate stabilization increases with the intratemporal elasticity of substitution.

► How inventory affects design of optimal monetary policies in small open economy. ► For trade elasticity smaller than 1, inventory does not affect optimal monetary policy. ► For trade elasticity larger than 1, inventory makes stabilizing exchange rate more important. ► Importance of exchange rate stabilization increases with trade elasticity.