Exchange Rate Pass-Through, Nominal Wage Rigidities, and Monetary Policy in a Small Open Economy

34 Pages Posted: 17 Oct 2018

See all articles by Jay Rhee

Jay Rhee

University of Windsor

Jeongseok Song

Chung-Ang University

Date Written: September 30, 2018

Abstract

This paper discusses the design of monetary policy in a New Keynesian small open economy framework by introducing nominal wage rigidities and incomplete exchange rate pass-through on import prices. Three main findings are summarized. First, with the existence of an incomplete exchange rate pass-through and nominal wage rigidities, the optimal policy is to seek to minimize the output gap, the variance of domestic price and wage inflation, as well as deviations from the law of one price. Second, the CPI inflation targeting Taylor rule is welfare enhancing when there is a technological shock to the economy. The exception occurs when there is a foreign income shock, which minimizes welfare losses under the domestic inflation targeting Taylor rule. Last, two stylized Taylor rules turn out to be a bad approximation, but the modified Taylor rules that respond to the unemployment gap rather than the output gap are a closer approximation to the optimal policy.

Keywords: Incomplete Pass-through, Nominal Wage Rigidities, Modified Taylor Rule, Monetary Policy, Small Open Economy

JEL Classification: E31, E58, F4

Suggested Citation

Rhee, Jay and Song, Jeongseok, Exchange Rate Pass-Through, Nominal Wage Rigidities, and Monetary Policy in a Small Open Economy (September 30, 2018). East Asian Economic Review Vol. 22, No. 3 (September 2018) 337-370, DOI: http://dx.doi.org/10.11644/KIEP.EAER.2018.22.3.347, Available at SSRN: https://ssrn.com/abstract=3264581 or http://dx.doi.org/10.2139/ssrn.3264581

Jay Rhee

University of Windsor ( email )

401 Sunset Avenue
Windsor, Ontario N9B 3P4
Canada

Jeongseok Song (Contact Author)

Chung-Ang University ( email )

221 Heuksuk-dong
Dongjak-gu
Seoul, 156-756
Korea, Republic of (South Korea)

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