To evaluate the effectiveness of targeting monetary policy strategies in a small open economy, we develop a dynamic optimizing model calibrated to recent Korean data. We then explore the consequences of alternative specifications of the loss function for society and the central bank, with particular focus on exchange rate volatility. Policy simulations include variations on inflation targeting, nominal income growth targeting and exchange rate targeting. Our results indicate that inflation targeting remains the most preferred policy regime, even when an explicit motive for exchange rate smoothing is introduced. In this case, the optimal inflation targeting and nominal income growth targeting policies are characterized by a “conservative” central bank that places greater weight on both the primary target variable and on the exchange rate than in society’s objective function. However, the optimal policy reacts to changes in degree of exchange rate pass-though in a non-linear fashion, complicating the robustness of inflation targeting recommendations for emerging markets.
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Paper provided by Wesleyan University, Department of Economics in its series Wesleyan Economics Working Papers with number
2005-007.
Find related papers by JEL classification: E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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