Anticipated shock, monetary policy and welfare in the small open economy

Abstract

This paper judges the welfare implications of anticipated and unanticipated Productivity shocks in a small open economy. The purpose model is two country New Keynesian dynamic stochastic general equilibrium model with the characteristics of nominal rigidities and monopolistic competition. This study finds out the higher degree of openness increase the welfare cost in the anticipated shocks. The response of optimal policy to anticipated shocks demonstrates the larger and delayed on macroeconomic variables than unanticipated shocks. Optimal monetary policy rule has a potential to curb the inflation and meet an optimal level of the real exchange rate volatility. Movements in real exchange rate resist the terms of trade externality and upturn the effectiveness of monetary policy. In addition, monetary authorities focus on the goal of exchange rate stabilization in their policy decisions.