Monetary Policy under Alternative Asset Market Structures: The Case of a Small Open Economy

Abstract

Can the structure of asset markets change the way monetary policy should be conducted? Following a linear‐quadratic approach, the present paper addresses this question in a New Keynesian small open economy framework. Our results reveal that the configuration of asset markets significantly affects optimal monetary policy and the performance of standard policy rules. In particular, when comparing complete and incomplete markets, the ranking of policy rules is entirely reversed, and so are the policy prescriptions regarding the optimal level of exchange rate volatility.