Yuliya Rychalovska THE IMPLICATIONS OF STRUCTURAL ASYMMETRIES FOR MONETARY POLICY AND WELFARE IN A SMALL OPEN ECONOMY : A LINEAR QUADRATIC FRAMEWORK CERGE

The paper analyzes optimal monetary strategy and policy trade-o¤s in a DSGE model of an open economy with traded and non-traded sectors. We approximate the utility of the representative consumer to obtain a micro-founded quadratic loss function of the form extensively used for monetary policy assessment. The central banks optimal strategy is computed and optimal and simple policy rules compared according to the derived welfare measure. The ndings suggest that social welfare objectives display sector-speci c features and prescribe the stabilisation of the appropriately weighted sectoral ination rates and output gaps. A certain degree of the relative price management is also optimal. We analyze macroeconomic volatility and welfare losses under a number of simple policy rules and analyze their ability to replicate the optimal solution. Abstrakt Tato práce analyzuje optimální mμenovou strategii a mμenovμe-politické konikty v DSGE modelu otμevrené ekonomiky s obchodovatelným a neobchodovatelným sektorem. Aproximací uμzitku reprezentativního agenta je získána kvadratická ztrátová funkce ve formμe, která je μcasto pouμzívána pri hodnocení mμenové politiky. Odvozená optimální strategie centrální banky je porovnávána s alternativními mμenovμe-politickými pravidly pomocí odvozeného mμeμrítka blahobytu. Výsledky naznaμcují, μze spoleμcensky optimální mμenová politika vykazuje sektorovμe speci cké charakteristiky a vyμzaduje stabilizaci pμríslunμe váμzených mμer inace a mezer výstupu. Urμcitý stupeμ n relativního μrízení cen je také optimální. Souμcasnμe analyzujeme makroekonomickou volatilitu a ztráty spoleμcenského blahobytu spojené s nμekolika rozliμcnými jednoduchými pravidly a posuzujeme jejich schopnost replikovat optimální μreení. Keywords: DSGE models, non-traded goods, optimal monetary policy, welfare JEL classi cation: E52, E58, E61, F41 I would like to thank Gianluca Benigno, Jan Bruha, Sergey Slobodyan, and Henri Sneessens for useful comments and suggestions yEmail: yuliya.rychalovska@cerge-ei.cz zA joint workplace of the Center for Economic Research and Graduate Education, Charles Univer1 1 Introduction In the world of dynamic interactions between economies through international trade, should policymakers account for various country-speci c features when implementing monetary strategy, or should they assume that welfare can be maximized under the uniform speci cation of the policy objectives? In other words, to what extent are the appropriate monetary policy targets endogenous to speci c characteristics such as country size, degree of openness, asymmetric economic and trading structure, and the level of development across countries? This paper aims to contribute to the discussion of these crucial issues of monetary policy design and practical implementation. The importance of taking a systematic approach to the conduct of monetary policy, featuring explicit formulation of policy objectives, has been rising in recent decades. Price stability has been recognized as the overriding policy goal by many monetary institutions worldwide. As a result, a new operational framework has been introduced by the most advanced central banks in order to match the o¢ cially stated goals of macroeconomic stabilization with their practical realization. Ination targeting, which implies a quantitative speci cation of the desired level of ination, has gained a reputation as being a strategy capable of generating stable and non-inationary growth, thus strengthening the policy credibility and reputation of the monetary authority. However, important features of modern economies, such as the social and economic consequences of unemployment, uncertainties of various types, asymmetric economic structure, and interrelations with the rest of the world, have brought about e¤orts to widen the range of policy objectives beyond ination (price) stability alone. Therefore, over the past several years, the attention of leading economists has turned to the issue of formal characterization of the proper monetary policy objectives. These concerns have spurred a variety of research attempting to shed some light on the question of whether strict ination targeting represents the optimal monetary policy from the welfare viewpoint. Addressing this topic is the most challenging when analyzing open economy models, where the formulation of policy targets appears to be more controversial compared to a closed economy setting. The central issue in the literature on open economies is the assessment of the implications of openness for the formulation of a central banks policy objectives and welfare analysis. In other words, the underlying questions are whether a central bank should also target open economy variables, i.e., the exchange rate, and how the targeting of domestic variables changes under the exposure of the economy to external sity, Prague, and the Economics Institute of the Academy of Sciences of the Czech Republic. Address: CERGE-EI, P.O. Box 882, Politických vμezμ n°u 7, Prague 1, 111 21, Czech Republic