Nontraded Goods and Deflationary Bias in a New Keynesian Open Economy Model

Abstract

This paper develops a New Keynesian open economy model that embeds nontraded goods and produces multiple discretionary equilibria arising in the form of expectations traps. In contrast to the results in previous studies, we find the presence of nontraded goods narrows the region for a deflationary monetary surprise, suggesting that it is critically important for central banks to control inflation expectations in open economies.