Monetary policy and welfare in a small open economy

Bianca De Paoli ()

Journal of International Economics, 2009, vol. 77, issue 1, pages 11-22

Abstract: This paper analyzes optimal monetary policy in a small open economy featuring monopolistic competition and nominal rigidities. It shows that the utility-based loss function for this economy can be written as a quadratic expression of domestic inflation, output gap and real exchange rate. The presence of an internal monopolistic distortion and a terms of trade externality drives optimal policy away from domestic inflation targeting and affects the optimal level of exchange rate volatility. When domestic and foreign goods are close substitutes for each other, the optimal policy rule implies lower real exchange rate volatility than a domestic inflation targeting regime. The reverse is true when the elasticity of substitution between goods is low.

Keywords: Welfare; Loss; function; Terms; of; trade; externality; Optimal; monetary; policy; Small; open; economy (search for similar items in EconPapers)
Date: 2009
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Related works:
Working Paper: Monetary Policy and Welfare in a Small Open Economy (2004)
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Persistent link: http://EconPapers.repec.org/RePEc:eee:inecon:v:77:y:2009:i:1:p:11-22

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