Uncertain Potential Output: Implications for Monetary Policy in a Small Open Economy

This paper considers the uncertain potential output in a small open economy New Keynesian model. Uncertainty comes from the difficulty to distinguish shocks in domestic versus foreign components of potential output in real time. In such a setup, the expansionary effects coming from an increase in potential output are reduced in size because, after an increase in productivity (foreign output) agents and the central bank believe that there is also a negative shock to foreign output (productivity). The paper also shows that the Taylor rule that guarantees the largest welfare does not include a term in the exchange rate. Finally, the exchange rate peg may perform better than an independent monetary policy, especially in the case of incomplete information.