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The Implications of Structural Asymmetries for Monetary Policy and Welfare in a Small Open Economy: A Linear Quadratic Framework

  • Yuliya Rychalovska
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    The paper analyzes optimal monetary strategy and policy trade-offs in a DSGE model of an open economy with traded and non-traded sectors. We approximate the utility of the repre- sentative consumer to obtain a micro-founded quadratic loss function of the form extensively used for monetary policy assessment. The central bank's optimal strategy is computed and optimal and simple policy rules compared according to the derived welfare measure. The findings suggest that social welfare objectives display sector-specific features and prescribe the stabilisation of the appropriately weighted sectoral inflation rates and output gaps. A certain degree of the relative price management is also optimal. We analyze macroeconomic volatility and welfare losses under a number of simple policy rules and analyze their ability to replicate the optimal solution.

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    File URL: http://www.cerge-ei.cz/pdf/wp/Wp380.pdf
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    Paper provided by The Center for Economic Research and Graduate Education - Economics Institute, Prague in its series CERGE-EI Working Papers with number wp380.

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    Date of creation: Dec 2008
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    Handle: RePEc:cer:papers:wp380
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    1. Claudio Soto, 2003. "Non-Traded Goods and Monetary Policy Trade-Offs in a Small Open Economy," Working Papers Central Bank of Chile 214, Central Bank of Chile.
    2. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 743-764, October.
    3. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
    4. Giancarlo Corsetti & Paolo Pesenti, 2001. "International dimensions of optimal monetary policy," Staff Reports 124, Federal Reserve Bank of New York.
    5. Erceg, Christopher & Levin, Andrew, 2006. "Optimal monetary policy with durable consumption goods," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1341-1359, October.
    6. Liu, Zheng & Pappa, Evi, 2005. "Gains from international monetary policy coordination: does it pay to be different?," Working Paper Series 0514, European Central Bank.
    7. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, vol. 77(1), pages 11-22, February.
    8. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
    9. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
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