Monetary Policy and Net Exports Externalities in the Small Open Economy

Abstract

We extend a New Keynesian small open economy dynamic stochastic general equilibrium (DSGE) model with nontradable goods and intermediate inputs. We show that the optimal monetary policy in the small open economy is not necessarily isomorphic to the closed economy due to net exports externalities. The optimal policymaker is willing to take advantage of the externalities and to raise the real value of home production, along with stabilizing composite domestic inflation. Also, we rank alternative monetary policy rules, estimate the optimal monetary policy rule associated with welfare, and show that setting interest rates toward their target levels of composite domestic inflation and net exports is desirable.