Interest Rate Smoothing and Inflation-Output Variability in a Small Open Economy ∗

This paper is concerned with the relationship between the interest rate smoothing behavior of a central bank and the variability of inflation and output. The issue is analyzed through the lens of a small open economy dynamic stochastic general equilibrium model with nontraded goods price rigidities and habit persistence. The benchmark model is calibrated to match certain key business cycle features of a small open economy like Australia. Relative to the benchmark model, experiments on a Taylor rule with interest rate smoothing are conducted. Due to the existence of a short run expectational Phillips curve in the model, monetary policy will imply certain trade-offs between inflation and output variance, under sensible parameter values of the model. More importantly, in a world where there exists such a trade-off, greater interest rate smoothing in the Taylor rule can potentially yield lower sacrifices in terms of output variability in return for lower inflation, thus increasing policy effectiveness.