Interest-rate smoothing in a two-sector small open economy

In this paper, interest-rate smoothing under Taylor-type rules is considered for an empirically plausible two-sector small open economy. A simple Taylor-type rule that has sufficient response to output gap, coupled with interest-rate smoothing, can improve welfare relative to our benchmark historical rule. This result is robust to alternative values of the degree of habit persistence and nontraded-goods price stickiness in the model. Alternatively, the interest-rate smoothing result may not hold when an strictly inflation-forecast-based (IFB) rule is used. However, incorporating sufficient response to contemporaneous output gap and inflation in the IFB rule, interest-rate smoothing can also deliver superior welfare outcomes.