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Optimal monetary policy in a small open economy with inflation and output persistence

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  • Rhee, Hyuk-jae
  • Turdaliev, Nurlan
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    Abstract

    We study optimal monetary policy for a small open economy in a model where both inflation and output show persistence. We incorporate habit formation into intertemporal consumption decision and modify the Calvo price setting to include indexation to past inflation. The message conveyed from this study can be viewed as twofold. First, full stabilization of domestic prices or the output gap is not optimal policy. This is because stabilization of the output gap leads to serial correlation in domestic inflation, whereas under full stabilization of domestic prices the output gap displays some serial correlation. It is, however, shown that at the zero inflation steady state, stabilizing domestic prices is equivalent to stabilizing the output gap. Second, in the presence of foreign income shock inflation and the output gap are more stable under flexible CPI inflation targeting than under other alternative policy regimes considered.

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    Bibliographic Info

    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 29 (2012)
    Issue (Month): 6 ()
    Pages: 2533-2542

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    Handle: RePEc:eee:ecmode:v:29:y:2012:i:6:p:2533-2542

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    Web page: http://www.elsevier.com/locate/inca/30411

    Related research

    Keywords: Inflation persistence; Output inertia; Monetary policy; Small open economy;

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