Monetary policy and welfare in a small open economy

Bianca De Paoli ()

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This paper characterizes welfare in a small open economy and derives the corresponding optimal monetary policy rule. It shows that the utility-based loss function for a small open economy is a quadratic expression in domestic inflation, output gap and real exchange rate. In contrast 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 closed economy and does not prescribe a pure floating exchange rate regime. Domestic inflation targeting is optimal only under a particular parameterization, where the unique relevant distortion in the economy is price stickiness. Under a general specification for preferences and in the presence of inefficient steady state output, exchange rate targeting arises as part of the 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)
Pages: 52 pages
Date: 2004-05
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (23)

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http://eprints.lse.ac.uk/19950/ Open access version. (application/pdf)

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:ehl:lserod:19950

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