Optimal monetary policy under heterogeneity in currency trade

Abstract

We embed an expectations-based optimal policy rule into a DSGE model for a small open economy that is augmented with trend extrapolation or chartism, which is a form of technical trading, in currency trade to examine the prerequisites for monetary policy. We find that a unique REE that is least-squares learnable is often the outcome when there is a limited amount of trend extrapolation, but that a less flexible inflation rate targeting may cause a multiplicity of REE. We also compute impulse-response functions for key macroeconomic variables to study how the economy returns to steady state after being hit by a shock. Keywords: determinacy, DSGE model, least-squares learning, targeting rule, technical trading, monetary policy JEL classification numbers: C62, E52, F31, F41