Monetary Policy in a Small Open Economy with a Preference for Robustness

We use robust control techniques to study the effects of model uncertainty on monetary policy in a small-open-economy model estimated on Australian data. Compared to the closed economy, the presence of open-economy transmission channels and shocks not only produces new trade-offs for monetary policy, but also introduces additional sources of specification errors. We find that price markup shocks in the domestic and import sector are important contributors to volatility in the model, and that the domestic and import sector Phillips curves are particularly vulnerable to model misspecification. On the other hand, deviations from the interest rate parity condition do not contribute much to overall volatility, nor is the parity condition especially vulnerable to misspecification. Our results suggest that it may be more important for central banks in small open economies to understand the nature of price setting and the effects of exchange rate movements on the economy than the determination of the exchange rate itself.