Financial Shocks and Optimal Monetary Policy in Small Open Economies ∗ Rodrigo Caputo † Central Bank of Chile

The aim of this paper is to analyze the optimal monetary policy response to financial shocks-an increase in interest rate spreads- in a small open economy. We show that the optimal response depends on: (i) the degree of correlation between the financial shock and foreign financial conditions and (ii) the extend to which the UIP condition holds with the policy interest rate or the market interest rate. In particular, if the financial shock is highly correlated with foreign financial conditions and if the UIP holds for the policy interest rate, then the policy trade-off will increase. On the contrary, if there is no correlation with foreign financial conditions and if the UIP holds for the market interest rate, the endogenous exchange rate adjustment is going to mitigate the negative impact of the financial shock. In this case, there is no policy trade-off and the policy rate will unambiguously fall. ∗We are grateful to Ursula Schwarzhaupt for superb research assistance. Preliminary version, comments are welcom