Monetary policy and welfare in a small open economy

De Paoli, Bianca (2004) Monetary policy and welfare in a small open economy. CEPDP (639). London School of Economics and Political Science. Centre for Economic Performance, London, UK. ISBN 0753017652

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Abstract

This paper characterizes welfare in a small open economy and derives the corresponding optimal monetary policy rule. It shows that the utility-based loss function for a small open economy is a quadratic expression in domestic inflation, output gap and real exchange rate. In contrast to previous works, this paper demonstrates that welfare in a small open economy, completely integrated with the rest of the world, is affected by exchange rate variability. Consequently, the optimal policy in a small open economy is not isomorphic to a closed economy and does not prescribe a pure floating exchange rate regime. Domestic inflation targeting is optimal only under a particular parameterization, where the unique relevant distortion in the economy is price stickiness. Under a general specification for preferences and in the presence of inefficient steady state output, exchange rate targeting arises as part of the optimal monetary plan.

Item Type:	Monograph (Discussion Paper)
Official URL:	http://cep.lse.ac.uk
Additional Information:	© 2004 Bianca De Paoli
Divisions:	Centre for Economic Performance Economics
Subjects:	H Social Sciences > HV Social pathology. Social and public welfare. Criminology H Social Sciences > HJ Public Finance
JEL classification:	E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects)
Date Deposited:	25 Jul 2008 09:48
Last Modified:	11 Dec 2024 18:37
URI:	http://eprints.lse.ac.uk/id/eprint/19950

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