Monetary Policy, Incomplete Asset Markets, and Welfare in a Small Open Economy


We develop a small open economy model with capital, sticky prices, and a simple form of financial frictions. We compare welfare levels under three alternative rules: a domestic inflation-based Taylor rule, a CPI inflation-based Taylor rule, and an exchange rate peg. We show that the superiority of an exchange rate peg over a domestic inflation-based Taylor rule becomes more pronounced under incomplete financial asset markets and more severe financial frictions.


Small open economy, DSGE, Welfare comparison, Incomplete financial market, Ramsey policy, Exchange rate regime

JEL Classification

E42, E44, E52, F31, F41, G15


Shigeto KITANO
Research Institute for Economics and Business Administration
Kobe University
Rokkodai-cho, Nada-ku, Kobe
657-8501 Japan
Phone: +81-78-803-7036
FAX: +81-78-803-7059

Faculty of Business, Aichi Shukutoku University