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The optimal choice of monetary policy instruments in a small open economy

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  • Rajesh Singh
  • Chetan Subramanian

Abstract

. This paper studies how the nature of shocks affects the optimal choice of monetary policy instruments in a small open economy. Three classic rules, fixed exchange rates, monetary targeting, and inflation targeting are studied and ranked by comparing with the optimal monetary policy under commitment. We find that the ranking of the simple rules can be mapped to the terms‐of‐trade variability that the rule allows relative to what a particular shock optimally calls for. It turns out that inflation targeting dominates the other two rules under productivity or velocity shocks, whereas monetary targeting is the best performer under fiscal shocks. Ce mémoire étudie comment la nature des chocs affecte le choix des instruments de politique monétaire dans une petite économie ouverte. On étudie trois règles classiques (taux de change fixes, cibles monétaires, cibles d'inflation) et on cherche laquelle semble préférable dans différentes conditions. On découvre que le rang de ces règles simples est reliéà la variabilité des termes d'échange que la règle permet par rapport à ce qu'un choc particulier commanderait optimalement. Les cibles d'inflation dominent les deux autres règles quand il s'agit de chocs de productivité et de vélocité, alors que les cibles monétaires sont préférables quand il s'agit de chocs fiscaux.

Suggested Citation

  • Rajesh Singh & Chetan Subramanian, 2008. "The optimal choice of monetary policy instruments in a small open economy," Canadian Journal of Economics/Revue canadienne d'économique, John Wiley & Sons, vol. 41(1), pages 105-137, February.
  • Handle: RePEc:wly:canjec:v:41:y:2008:i:1:p:105-137
    DOI: 10.1111/j.1365-2966.2008.00457.x
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