The Expenditure Switching Effect, Welfare and Monetary Policy in a Small Open Economy

Abstract

This paper analyses the implications of the 'expenditure switching effect' for the role of the exchange rate in monetary policy in a small open economy. It is shown that, when the elasticity of substitution between home and foreign goods is not equal to unity, welfare depends on the variances of producer prices and the terms of trade. Producer-price targeting is compared to consumerprice targeting and a fixed exchange rate. It is found that a fixed exchange rate yields higher welfare than the other regimes only when the elasticity of substitution between home and foreign goods is very high.