Working Paper

Reaction functions in a small open economy: What role for non-traded inflation?

Abstract: I develop a structural general equilibrium model and estimate it for New Zealand using Bayesian techniques. The estimated model considers a monetary policy regime where the central bank targets overall inflation but is also concerned about output, exchange rate movements, and interest rate smoothing. Taking the posterior mean of the estimated parameters as representing the characteristics of the New Zealand economy, I compare the consequences that two alternative reaction functions have on the central bank's loss, for different specifications of its preferences. I obtain conditions under which the monetary authority should respond directly to non-tradable inflation instead of overall inflation. In particular, if preferences are relatively biased towards inflation stabilization, responding directly to overall inflation results in better macroeconomic outcomes. If instead the central bank places relatively more weight on output stabilization, responding directly to non-traded inflation is a better strategy.

Keywords: monetary policy; non-traded inflation; reaction functions; small open economy;

JEL Classification: C51; E52; F41;

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2005-06-01

Number: 2014-44

Pages: 55 pages