Monetary Policy in Open Economies with Production Networks

This paper investigates the design of monetary policy in small open economies with domestic and cross-border input-output linkages and nominal rigidities. Aggregate distortions are proportional to the aggregate output gap, which can be expressed as a weighted average of sectoral markup wedges that encapsulate the inefficiency in each sector. Monetary policy can close the output gap and offset the sectoral distortions by stabilizing the aggregate index of inflation that weights inflation in each sector based on the degree of nominal rigidities and the centrality of the sector as a supplier of inputs and a net exporter of products within the international production networks. To close the output gap, monetary policy should assign larger weights to inflation in sectors with small direct or indirect (via the downstream sectors) import shares, and failing to account for the cross-border production networks overemphasizes the inflation in sectors that export intensively directly and indirectly (via the downstream sectors), generating quantitatively significant welfare losses that rise with the degree of openness of the economy. We derive the closed-form solution for the optimal monetary policy that minimizes the welfare losses up to the second-order approximation and show that the OG policy generates welfare losses quantitatively close to the optimal policy and, therefore, is nearly optimal.