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

Hyuk-jae Rhee and Nurlan Turdaliev

Economic Modelling, 2012, vol. 29, issue 6, 2533-2542

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.

Keywords: Inflation persistence; Output inertia; Monetary policy; Small open economy (search for similar items in EconPapers)
JEL-codes: E31 E58 F41 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:29:y:2012:i:6:p:2533-2542

DOI: 10.1016/j.econmod.2012.08.012

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