International Trade Fluctuations and Monetary Policy
24 Pages Posted: 8 Sep 2015 Last revised: 10 Sep 2015
Date Written: September 8, 2015
Abstract
This paper studies the role of trade openness for the design of monetary policy. We extend a standard small open economy model of monetary policy to capture cyclical fluctuations of international trade flows, and parametrize it to match key features of the data. We find that accounting for trade fluctuations matters for monetary policy: when the monetary authority follows a Taylor rule, inflation and the output gap are more volatile. Moreover, we find that the volatility of these variables is significantly higher when the central bank follows the optimal policy based on a model that cannot account for international trade fluctuations.
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