Implementable Optimal Monetary Policy in a Small Open Economy

Abstract

This paper sets up a small open economy with nominal price rigidities to analyze an implementable optimal monetary policy. It shows that the domestic price index inflation targeting rule is not optimal in the small open economy with non-unitary intertemporal and intratemporal elasticities of substitution among goods. This reflects the fact that the terms of trade gap or the real exchange rate gap also affects the welfare of the representative household with a CRRA preference function. The paper also shows that the interest rate rule responding to the exchange rate gap as well as output gap and inflation gap is better than the interest rate rule disregarding the exchange rate gap in terms of the welfare cost.