Optimal Monetary Policy in a Small Open Economy with Non-tradable Goods

This paper studies optimal monetary policy in a small open economy DSGE model with non-tradable goods and sticky prices. The introduction of non-traded goods is shown to have important implications for the transmission of shocks and monetary policy arrangements. First, the results show that positive technology shocks need not lead to deflation. In response to technology shocks, real exchange rates and the terms of trade depreciate. The relative price of tradable to non-tradable goods may increase or decrease, depending on the shocks. Second, based on welfare analysis, this paper evaluates the performance of different interest rate rules. The results show that if monetary policy is not very aggressive, the Taylor-type interest rate policy that targets CPI inflation performs the best. However, as monetary policy becomes relatively aggressive, the policy that targets domestic inflation is shown to yield the highest level of welfare. Third, this paper studies the Ramsey policy and optimal allocations. The results indicate that the Ramsey optimal policy stabilizes the inflation rates in both production sectors, while allowing for volatilities in CPI inflation, real exchange rates, the terms of trade, and the relative price of tradable goods. This suggests that the interest rate rules targeting CPI inflation or exchange rates are suboptimal. The results also show that in response to sector specific shocks, the Ramsey planner only cares about the inflation rate in the sector where the shock originates.