Real wage rigidities and optimal monetary policy in a small open economy

•We incorporate real wage stickiness into a small open economy model.•Optimal policy uses domestic inflation, real wage inflation, and output gap.•The policy that responds to CPI inflation is suboptimal.•The policy that targets real wage inflation is almost as good as the optimal policy.

The main objective of the study is to provide a theoretical analysis of optimal monetary policy in a small open economy where households set real wage in a staggered fashion. The introduction of real wage rigidities plays a important role to resolve main shortcomings of the standard new Keynesian small open economy model. The main findings regarding the issue of monetary policy design can be summarized as three fold. First, the optimal policy is to seek to minimize variance of domestic price inflation, real wage inflation, and the output gap if both domestic price and real wage are sticky. Second, controlling CPI inflation directly or indirectly induces relatively large volatility in output gap and other inflations. Therefore, both CPI inflation-based Taylor rule and nominal wage-inflation based Taylor rule are suboptimal. Last, a policy that responds to a real wage inflation is most desirable.