Rules versus discretion on the choice between exchange‐rate‐targeting and monetary‐aggregate‐targeting

Abstract

This paper compares the performance of inflation and welfare loss between exchange‐rate‐targeting and monetary‐aggregate‐targeting regimes for a small‐open economy characterized by a rational expectations model of the Phillips curve. We also consider rules‐versus‐discretion in policy. We obtain three interesting results. First, both regimes result in the same target rate of inflation and the smallest long‐run welfare loss, if an active contingent rule is credibly followed. Second, when discretion is undertaken, an exchange‐rate‐targeting policy is always superior to a monetary‐aggregate‐targeting one. Third, for a simple fixed rule, Friedman‐type’s monetary‐aggregate‐targeting policy works better than exchange‐rate‐targeting only under specific circumstances.