The implications of sectoral heterogeneity for monetary policy and welfare in a small open economy: a linear quadratic framework

The paper analyzes optimal monetary strategy and policy trade-o§s in a DSGE model of an
open economy with traded and non-traded sectors. We approximate the utility of the representative consumer to obtain a micro-founded quadratic loss function of the form extensively
used for monetary policy assessment. The central bankís optimal strategy is computed and
optimal and simple policy rules compared according to the derived welfare measure. The
Öndings suggest that social welfare objectives display sector-speciÖc features and prescribe
the stabilisation of the appropriately weighted sectoral ináation rates and output gaps. A
certain degree of the relative price management is also optimal. We analyze macroeconomic
volatility and welfare losses under a number of simple policy rules and analyze their ability
to replicate the optimal solution.