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Monetary policy and welfare in a small open economy

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

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Identification Number: 639

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
Subjects: H Social Sciences > HV Social pathology. Social and public welfare. Criminology
H Social Sciences > HJ Public Finance
Sets: Collections > Economists Online
Research centres and groups > Centre for Economic Performance (CEP)
Departments > Economics
Date Deposited: 25 Jul 2008 09:48
Last Modified: 01 Oct 2010 09:13
URI: http://eprints.lse.ac.uk/id/eprint/19950

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