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

Author

Listed:
  • Levine, Paul
  • McKnight, Stephen
  • Mihailov, Alexander
  • Swarbrick, Jonathan

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.

Suggested Citation

  • Levine, Paul & McKnight, Stephen & Mihailov, Alexander & Swarbrick, Jonathan, 2025. "Limited asset market participation and monetary policy in a small open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 173(C).
    • Handle: RePEc:eee:dyncon:v:173:y:2025:i:c:s0165188925000132
    DOI: 10.1016/j.jedc.2025.105047
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    Keywords

    Limited asset market participation; Small open economy; Inverted aggregate demand logic; Equilibrium determinacy; Interest-rate inertia; Optimal monetary policy;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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