The Desirable Smooth Operator, Incomplete Pass Through and the “Zero Bound”

The typical New-Keynesian small-open-economy model has qualitative features and monetary-policy prescriptions similar to their original closed-economy counterparts ?i.e. complete stabilization of domestic inflation is sufficient for optimal policy. We consider a version of the model here where that isomorphism no longer holds and where the zero-interest-rate lower bound matters. Under the commitment benchmark, the optimal interest-rate rule is intrinsically inertial. Under time-consistent policy, it is still optimal to delegate policy to an interest-rate smoothing central banker despite the fact that complete stabilization of domestic inflation is no longer possible. We thus extend the analysis of Woodford (1999) to a nontrivial small open economy setting. Our result is robust to alternative degrees of pass through, the types of shocks impinging the natural rate, and minor departures from optimal pricing behavior.