Optimal Exchange Rate Policy for a Small Oil-Exporting Country: A Dynamic General Equilibrium Perspective

Abstract

This paper investigates the choice of optimal exchange rate regime for an oil-exporting small open economy, a case relevant to a large number of primary-commodity economies, in which the terms-of-trade are driven by world commodity price cycle. The new Keynesian small open economy model is extended to include three countries, a small commodity-exporting country (Home) and two large foreign countries. The sources of uncertainty are random monetary (demand), productivity (real), and oil-price (supply) shocks. Despite the nonexistence of a traded sector (other than crude-oil exports) in this primary-commodity economy, the welfare analyses show that flexible exchange rate regimes can reduce terms-of-trade and consumption volatility given certain caveats about pricing-schemes. The analyses also suggest that a basket peg is more welfare-improving compared to a unilateral peg. Further, the variance of the currency in which oil-price is denominated came as an important determinant in welfare analyses. These conclusions have important policy implication, particularly for the Gulf Cooperation Council (GCC) countries as they consider alternative monetary arrangements.