Uncertain Potential Output and Simple Rules in Small Open Economy

Abstract

This paper analyzes the implications of incomplete information for the conduct of monetary policy in small-open economy. I use a standard theoretical DSGE model to evaluate the performance of simple rules, including the exchange rate peg. Incomplete information is modeled assuming that the central bank and the private sector observe domestic inflation and output with a measurement error, while they do not observe potential output. I show that not reacting to the exchange rate yields better outcomes in terms of a standard loss function. For the case of complete information and incomplete information, I quantify for which parameter configuration a Taylor rule reacting to both the exchange rate and the domestic inflation rate yields a higher loss than the fixed exchange rate regime.