Optimal Monetary Policy under Balance-Sheet Effects on the Non-tradable Sector in a Small Open Economy

The choice of an exchange rate regime is crucial in small open economies (SOEs) with a dollarized financial sector. While the traditional Mundell–Fleming model supports a floating exchange rate, evidence shows that central banks frequently intervene in exchange markets. One of the reasons for these interventions is the consequences of large depreciations that could trigger negative balance-sheet effects. This paper extends the literature about the optimal monetary policy in SOEs, by considering a heterogeneous hedge across tradable and non-tradable sectors. Our findings support a ‘leaning against the wind’ policy as an optimal response to negative external shocks. This result is present even if only one sector of the economy faces credit constraints. We show that the vulnerability of the economy to large negative external shocks depends not only on the overall leverage, but also on the distribution of foreign currency debt across economic sectors.