Optimal Monetary Policy under Asset Market Segmentation

This paper studies optimal monetary policy in a small open economy under flexible prices. The paper’s key innovation is to analyze this question in the context of environments where only a fraction of agents participate in asset market transactions (i.e., asset markets are segmented). In this environment, we first show that there exist state contingent rules (based either on the rate of money growth or the devaluation rate) that can implement the first-best equilibrium. Such rules, however, would require the monetary authority to respond to contemporaneous shocks and would thus be difficult to implement. We then proceed to analyze optimal monetary policy rules within the class of non-state contingent rules. Our main result is that amongst non-state contingent rules, policies targeting monetary aggregates (which allow for nominal exchange rate flexibility) welfare-dominate rules that target the exchange rate. In particular, we find that a fixed exchange rate is never optimal. Our analysis would thus tend to support monetary policy arrangements that allow for nominal exchange rate flexibility