Monetary policy changes could impact inflation and trade in open economies
The article explores how incomplete pass-through in import goods prices affects optimal monetary policy. It shows that this deviation from the law of one price makes open economy monetary policy different from closed economy policy. Incomplete pass-through creates a tradeoff between stabilizing inflation and the output gap in response to productivity shocks. Optimal commitment policy smooths deviations from the law of one price and requires more stable exchange rates compared to discretion.