The Implications of the Asymmetric Price Rigidity for the Monetary Policy in an Open Economy

Abstract

There is convincing empirical evidence that prices are asymmetrically rigid in response to positive and negative demand shocks. Such asymmetry should play an important role in monetary policy. I analyze the implications of the asymmetric price rigidity for the optimal monetary policy in a microfounded New Keynesian model of a small open economy. I find that inflationary and deflationary shocks should be treated asymmetrically in the presence of asymmetric price rigidity but that the asymmetry depends on the local price rigidity and the social preferences. In particular, if prices are sufficiently flexible and/or the output gap is not very important (e.g., if there is strict inflation targeting), then the monetary policy should respond more to inflationary shocks than to deflationary ones of the same size. In the opposite case, however, the optimal asymmetry is reversed. This model attempts to explain in terms of the social preferences why different directions in the monetary policy asymmetry are observed in different countries, and provide normative prescriptions for the design of monetary policy in the presence of asymmetric price rigidity..