Terms of Trade Externality, Sterilized Interventions and Optimal Chinese Monetary Policy

We incorporate terms-of-trade externality into a small open economy featuring an incomplete market, sterilized intervention, and capital controls as in Chang et al. (2015), and we highlight the central banks reaction to exchange rate movement. Our calibrated model using data from China shows that an optimal monetary policy is crucially dependent on the Armington elasticity between domestic and foreign goods. For a wide range of Armington elasticity values, an intermediate exchange rate regime dominates the bipolar (fixed or floating) exchange regimes in terms of welfare gains