Monetary Policy and Welfare in a Small Open Economy

Bianca De Paoli ()

CEP Discussion Papers from Centre for Economic Performance, LSE

Abstract: This paper characterizes welfare in a small open economy and derives the correspondingoptimal monetary policy rule. It shows that the utility-based loss function for a small openeconomy is a quadratic expression in domestic inflation, output gap and real exchange rate. Incontrast to previous works, this paper demonstrates that welfare in a small open economy,completely integrated with the rest of the world, is affected by exchange rate variability.Consequently, the optimal policy in a small open economy is not isomorphic to a closedeconomy and does not prescribe a pure floating exchange rate regime. Domestic inflationtargeting is optimal only under a particular parameterization, where the unique relevantdistortion in the economy is price stickiness. Under a general specification for preferencesand in the presence of inefficient steady state output, exchange rate targeting arises as part ofthe optimal monetary plan.

Keywords: Welfare; Optimal Monetary Policy; Small Open Economy (search for similar items in EconPapers)
JEL-codes: E52 E58 E61 F41 (search for similar items in EconPapers)
Date: 2004-05
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (60)

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Related works:
Journal Article: Monetary policy and welfare in a small open economy (2009)
Working Paper: Monetary policy and welfare in a small open economy (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:cep:cepdps:dp0639

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