A Two Sector Small Open Economy Model. Which Inflation to Target?

This paper analyses welfare-improving monetary policy reaction functions in the context of a new-Keynesian small open economy model with a tradables and a non-tradables sector. The model is estimated for the case of Canada and used to evaluate the welfare gains of alternative specifications of the feedback nominal interest rate rule, in particular when allowing for different coefficients on the sectorial inflation rates. We find reasonable estimates for the deep parameters of the model , which include significant heterogeneity in the degree of price rigidity across sectors, as well as reasonable quantitative responses to sectorial and aggregate variables to local and foreign shocks. We find welfare gains in responding somehow more aggressively to aggregate inflation deviations from target than it has been the case in the last three decades and substantial welfare losses if the Bank of Canada aimed at stabilizing output more aggressively. But we find substantial further welfare gains of being more aggressive on imported inflation than on domestic sectors inflation since it is imports prices those that show a higher level of estimated stickiness