Is there a Role for International Trade Costs in Explaining the Central Bank Behavior?

This paper develops an open-economy DSGE model to analyze the effects of international trade costs on monetary policy of open economies. The implications of this micro-founded New-Keynesian model are tested on a prototype small economy that is open to international trade costs shocks, Canada. When a utility-based expected loss function is considered, the central bank is found to be far from being optimal in its actions, independent of international trade costs. When an ad hoc expected loss function considering the volatilities in inflation, output and interest rate is considered, it is found that the actions of the central bank are explained best when international trade costs in fact exist but the central bank ignores them. Given the ad hoc loss function, the actions of the central bank are best explained when 70% of weight is assigned to inflation, 15% of weight to interest rate and 15% of weight to output.