The Choice of Monetary Policy Regime for Small Open Economies

Abstract

Inflation targeting and exchange rate targeting, including monetary union, are analyzed in a simple, estimated macroeconomic model of a small open economy. Flexible inflation targeting produces lower nominal and real variability than exchange rate targeting, because the lat- ter gives rise to persistent oscillations in the real interest rate and the real exchange rate due to the ' Walters' effect'. We find, however, that with com- mitment to simple instrument rules, the performance of flexible inflation tar- geting can almost be matched