Optimal Monetary Policy in a Small Open Economy With Habit Persistence

ABSTRACT This paper presents up a canonical New Keynesian small open economy model with habit persistence in consumption. The presence of habit persistence complicates the attainment of domestic price stability in the small open economy. The monetary authority may need to deviate from price stability to address the distortions linked to habit persistence, even if households exhibit the Cole–Obstfeld preference. This finding contrasts with previous studies. The paper also highlights the importance of the implementability of taxation/subsidy policies in achieving the efficient steady state and the welfare implications of different monetary policy rules. The results suggest that a time‐invariant tax on labour income to achieve the efficient steady state favours a domestic product price inflation targeting rule over other simple rules. However, if this tax is not feasible, an exchange rate peg may outperform a domestic product price index inflation targeting rule, even with moderate values of intratemporal elasticity of substitution.