Optimal Monetary Policy and Weather Shocks in Small Open Economies

Climate change has led to an increase in extreme weather events, causing significant challenges for macroeconomic stability and monetary policy, particularly in small open economies (SOEs). This paper investigates the optimal monetary policy response to weather shocks in an SOE framework, using a Dynamic Stochastic General Equilibrium (DSGE) model calibrated for Turkey. The model includes sectoral price rigidities, trade openness, and climate-related productivity shocks affecting agricultural output. We evaluate alternative monetary policy rules, including those that target aggregate inflation, sector-specific inflation, and output stabilization. Our findings suggest that an aggressive monetary policy response to agricultural inflation mitigates short-term economic disruptions and accelerates recovery, albeit at the cost of a deeper initial contraction. The Ramsey-optimal policy prioritizes inflation stability while minimizing the long-term persistence of weather-induced output losses. Our results offer insights into the role of monetary policy in addressing climate-induced economic fluctuations in SOEs, highlighting the importance of tailored monetary policies that account for sectoral heterogeneities.