Limited asset market participation and monetary policy in a small open economy

Abstract

Limited asset market participation (LAMP) and trade openness are crucial features that characterize all real-world economies. We study equilibrium determinacy and optimal monetary policy in a model of a small open economy with LAMP. With low enough participation in asset markets, conventional wisdom concerning the stabilizing benefits of policy inertia can be overturned, irrespective of the constraint of a zero lower bound on the nominal interest rate. In contrast to recent studies, trade openness can play an important stabilizing role in LAMP economies. Optimal monetary policy is derived as a robust timeless rule, where the optimal level of interest-rate inertia depends on the degree of trade openness. The optimal rule is shown to be super-inertial for standard economies, whereas the degree of inertia is significantly lower and not super-inertial for LAMP economies.