The desirable smooth operator, incomplete pass through and the "zero bound"

Vol: 
03/2006
Author name: 
Kam T
Year: 
2006
Month: 
January
Abstract: 

The typical New-Keynesian small-open-economy model has qualitative features and monetary-policy prescriptions similar to their original closed-economy counterparts –i.e. complete stabilization of domestic inflation is sufficient for optimal policy. We consider a version of the model here where that isomorphism no longer holds and where the zero-interest-rate lower bound matters. Under the commitment benchmark, the optimal interest-rate rule is intrinsically inertial. Under time-consistent policy, it is still optimal to delegate policy to an interest-rate smoothing central banker despite the fact that complete stabilization of domestic inflation is no longer possible. We thus extend the analysis of Woodford (1999) to a nontrivial small open economy setting. Our result is robust to alternative degrees of pass through, the types of shocks impinging the natural rate, and minor departures from optimal pricing behavior.

Publication file: 

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