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Can exchange rate rules be better than interest rate rules?

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  • Teo, Wing Leong

Abstract

We develop a New Keynesian small open economy model to compare the welfare performances of two classes of monetary policy rules: exchange rate rules and interest rate rules. The expected lifetime utility of the representative household is used as the welfare criterion. The model is solved using second-order approximation methods. We find that under benchmark parameterization, an exchange rate rule delivers lower standard deviations of GDP and inflation compared to an interest rate rule, when the economy has a high degree of openness. However, despite that, an exchange rate rule is welfare inferior to an interest rate rule since it delivers lower mean terms of trade, which leads to lower mean consumption and higher mean labor hours. On the other hand, when the elasticity of substitution for export is high, an exchange rate rule is welfare superior to an interest rate rule, regardless of the degree of openness, as the differences in mean terms of trade for the two classes of rules become smaller.

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Bibliographic Info

Article provided by Elsevier in its journal Japan and the World Economy.

Volume (Year): 21 (2009)
Issue (Month): 3 (August)
Pages: 301-311

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Handle: RePEc:eee:japwor:v:21:y:2009:i:3:p:301-311

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Web page: http://www.elsevier.com/locate/inca/505557

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Keywords: Exchange rate rules Interest rate rules Monetary policy Welfare comparison Small open economy;

References

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Cited by:
  1. Teo, Wing Leong, 2011. "Inventories and optimal monetary policy in a small open economy," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1719-1748.

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