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Optimal Monetary Policy in a Small Open Economy Under Segmented Asset Markets and Sticky Prices

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  • Juan Pablo Medina Guzman
  • Ruy Lama

Abstract

This paper studies optimal monetary policy in a two-sector small open economy model under segmented asset markets and sticky prices. We solve the Ramsey problem under full commitment, and characterize the optimal monetary policy in a calibrated version of the model. The findings of the paper are threefold. First, the Ramsey solution mimics the allocations under flexible prices. Second, under the optimal policy the volatility of non-tradable inflation is close to zero. Third, stabilizing nontradable inflation is optimal regardless of the financial structure of the small open economy. Even for a moderate degree of price stickiness, implementing a monetary policy that mitigates asset market segmentation is highly distortionary. This last result suggests that policymakers should resort to other policy instruments in order to correct financial imperfections.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/217.

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Length: 55
Date of creation: 01 Sep 2007
Date of revision:
Handle: RePEc:imf:imfwpa:07/217

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Keywords: Financial assets; Markets; Economic models; monetary policy; inflation; asset market; market segmentation; nominal interest rate; tradable goods; open economy; inflation rate; price stability; inflation targeting; aggregate demand; elasticity of substitution; political economy; monetary economics; price level; foreign currency; transactions costs; relative price; real money; closed economy; relative prices; perfect competition; inflation stabilization; intermediate goods; constant elasticity of substitution; trade integration; wage inflation; high inflation; inflation target; price fluctuations; equilibrium model; annual inflation rate; exchange rate policy; real wages; exchange rate regime; exchange rate regimes; money supply; net exports; inflation dynamics; annual inflation; domestic price;

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Cited by:
  1. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics 19950, London School of Economics and Political Science, LSE Library.
  2. Fernando E. Alvarez & Francesco Lippi, 2011. "Persistent Liquidity Effects and Long Run Money Demand," NBER Working Papers 17566, National Bureau of Economic Research, Inc.

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