https://macropaperwarehouse.com/authors/le-xu/Le XuHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/monetary-policy-in-open-economies-with-production-networks/https://macropaperwarehouse.com/papers/monetary-policy-in-open-economies-with-production-networks/<p>This paper studies the design of monetary policy in a multi-sector small open economy with domestic input-output linkages and cross-border production networks, under nominal price rigidities in domestic sectors. The main result is that the monetary policy that closes the domestic output gap is nearly optimal, and it is implemented by stabilizing an aggregate inflation index that weights each sector&rsquo;s inflation by its role as a supplier of inputs and a net exporter within the international production network. Sectors with small direct or indirect import shares receive large weight in the index; ignoring cross-border linkages leads monetary policy to overemphasize inflation in sectors that are intensive exporters directly or indirectly through downstream sectors. Three channels link sectoral markup wedges to the aggregate output gap: the CPI channel (present in closed economies too) and the net export income and net profit income channels (unique to open economies with cross-border linkages). Using the World Input-Output Database, the output-gap-closing policy is shown to outperform alternatives that abstract from economic openness or input-output linkages.</p>