Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Understanding the costs and benefits of alternative monetary policy rules is important for economic welfare. Within the context of a small open economy model and building on the work of Mihov and Santacreu (2013), the author analyzes the economic implications of two monetary policy rules. The first is a rule in which the central bank uses the nominal exchange rate as its policy instrument and adjusts the rate whenever there are changes in the economic environment. The second is a standard interest rate rule in which the central bank adjusts the short-term nominal interest rate to changes in the economic environment. The main finding of the analysis is that, if the uncovered interest parity condition that establishes a tight link between the interest rate differential in two countries and the expected rate of depreciation of their currencies does not hold, the exchange rate rule outperforms the standard interest rate rule in lowering the volatility of key economic variables. There are two main reasons for this: First, the actual implementation of the exchange rate rule avoids the overshooting effect on exchange rates characteristic of an interest rate rule. And second, the risk premium that generates deviations from the uncovered interest parity condition is smaller and less volatile under an exchange rate rule.