Monetary Policy Analysis in an Open Economy with Incomplete Asset Markets

A dynamic stochastic general equilibrium monetary model with incomplete asset markets, nominal price rigidities and market imperfections is developed to shed light on the role of exchange rate and its relation with current account dynamics in the formulation of monetary policy. In the recent literature, labelled as new open economy macroeconomics (NOEM), the dynamics of current account do not matter for monetary policy due to the assumption of complete asset markets in most papers. (e.g., Clarida, Gali and Gertler (AER, 2001)). However, as pointed out by Obstfeld and Rogoff (JPE, 1995), the assumption of complete asset markets is not realistic in a model with imperfections and rigidities in goods market because with nominal rigidities monetary policy will affect real variables including the current account. With incomplete asset markets the dynamics of current account do matter for monetary policy because then, besides dealing with the distortions created by monopolistic competition, the central bank need to address the inefficiencies caused by incomplete asset markets. Moreover, the role of exchange rate in the formulation of monetary policy in NOEM models is far from being settled. The main result of the paper is the breakdown of a widely accepted result reported by Clarida, Gali and Gertler (AER, 2001) in a similar model of an open economy. Extending their closed economy analysis, they argue that optimal monetary policy calls for adjusting the interest rate to completely offset demand shocks, which implies no trade-off between output volatility and inflation volatility. However, I have shown in this paper that when exchange rate affects both aggregate demand and inflation, adjusting the interest rate to stabilize output in the face of a demand shock will cause fluctuations in inflation. Thus, the optimal monetary policy calls for trading-off some output volatility for less inflation volatility. Moreover, due to the dynamic interaction between current accounts and the real exchange rate, the optimal monetary policy also entails a response to net foreign asset positions and the impact of the demand shock last well beyond the time interval in which prices are rigid. JEL Classification: E52, F41