Abstract
This paper analyzes the optimal monetary policy in small open economies featuring monopolistic competition and nominal rigidity. Due to the presence of the external distortion, the optimal monetary policy in a small open economy can deviate from its closed-economy counterpart in that complete domestic inflation stabilization is not optimal in general. The policy discrepancy between closed and open economies vanishes if the elasticity of substitution between domestic and foreign goods goes to infinity. The numerical results suggest that the design of optimal monetary policy depends crucially on whether a corrective asset tax is available. If the inefficiency in asset trading can be eliminated by an asset tax the optimal monetary policy exhibits little volatility in domestic inflation. In contrast, the optimal volatility of domestic inflation becomes much greater when an asset tax is unavailable. This paper also shows that the common practice that excludes the current-account equation from the optimal policy problem may lead to spurious results.