Inequality and Optimal Monetary Policy in the Open Economy

Abstract

We study optimal monetary policy in a tractable Small Open Economy Heterogeneous-Agent New Keynesian (SOE-HANK) model in which households face uninsured idiosyncratic risk and unequal bond market access. We derive conditions under which optimal policy in our SOEHANK economy entails domestic producer price stability, extending the “open-economy divine coincidence” result of Gal´ı and Monacelli (2005) beyond the Representative-Agent benchmark (SOE-RANK). Away from those conditions, inefficient fluctuations in consumption inequality generate new monetary policy tradeoffs. Under plausible calibrations for the trade elasticities, the elasticity of intertemporal substitution, and the cyclicality of income risk, the central bank stabilizes output and the exchange rate more than in SOE-RANK.