International Interest Rate Shocks and Monetary Policy in a Small Open Economy

Considering that a significant part of business cycle fluctuations in small open economies could be explained by international interest rate shocks, this paper attempts to characterize the monetary policy rule that is optimal among simple and implementable rules for an economy where international interest rate shocks work as main sources of business cycles. For this purpose, the performances of various monetary policy rules are compared in terms of social welfare based on a standard small open economy model. The main findings of this paper are as follows. First, for a small open economy vulnerable to international interest rate shocks, domestic goods price inflation targeting is the optimal policy rule within a family of simple and implementable monetary policy rules. Second, it is found that exchange rate fluctuations implied by inflation targeting rule expose the monetary authority to a trade-off between total demand stabilization and increased volatility of inflation.