Monetary Policy and the International Implications of the Phillips Curve in an Open Economy

In this paper I examine optimal monetary policy and the informational implications of the Phillips curve in a stochastic model of a small open economy. It is assumed that the economy produces both traded and non-traded goods, that capital mobility is perfect and that the economy faces a variety of unanticipated transitory disturbances to demand, supply and the foreign sector. It is also assumed that wages are not only indexed to the price level, but also respond to the state of the labour market. If the authorities have only imperfect information about current disturbances, this gives independent informational content to wages, over and above the information conveyed by other aggregate prices. The optimal policy in this model involves not only intervention in the foreign exchange market but also accommodation of wage growth, as the exchange rate and wages are only partially correlated signals about the unobserved disturbances.