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Alternative Monetary Rules in the Open Economy: A Welfare-Based Approach

In: Inflation Targeting: Desing, Performance, Challenges

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  • Eric Parrado

    (Ministerio de Hacienda, Gobierno de Chile)

  • Andrés Velasco

    (Ministerio de Hacienda, Gobierno de Chile)

Abstract

Using an optimizing model we compare alternative monetary policy rules and exchange rate regimes for a small stochastic open economy with imperfect competition and short run price rigidity. The criteria to choose among rules and regimes are obtained using a welfare criterion derived from the utility function of the representative agent. The main findings of this paper are that, depending on what shocks affect this economy, the effects of inflation targeting on output and inflation volatility depend crucially on the exchange rate regime and the inflation index being targeted. With regard to the exchange rate, we find that the loss in agents’ welfare is much higher under managed exchange rates than under flexible rates in presence of real shocks, while for nominal shocks the reverse is true. As far as the definition of inflation targeting index is concerned, domestic inflation appears to outperform the CPI. Finally, flexible inflation targeting is welfare superior to strict targeting.
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Eric Parrado & Andrés Velasco, 2002. "Alternative Monetary Rules in the Open Economy: A Welfare-Based Approach," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.),Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 7, pages 295-348, Central Bank of Chile.
  • Handle: RePEc:chb:bcchsb:v05c07pp295-348
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    References listed on IDEAS

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    Cited by:

    1. Jose De Gregorio & Andrea Tokman R., 2004. "Overcoming Fear of Floating: Exchange Rate Policies in Chile," Working Papers Central Bank of Chile 302, Central Bank of Chile.
    2. Pablo Gonzalez & Mauricio Tejada, 2006. "No linealidades en la regla de política monetaria del Banco Central de Chile: una evidencia empírica," Revista de Analisis Economico – Economic Analysis Review, Universidad Alberto Hurtado/School of Economics and Business, vol. 21(1), pages 81-115, July.
    3. Ravenna, Federico, 2005. "The European Monetary Union as a commitment device for new EU member states," Working Paper Series 516, European Central Bank.
    4. Rodrigo Caputo, 2004. "Habit formation and its implications for small open economies," Money Macro and Finance (MMF) Research Group Conference 2003 11, Money Macro and Finance Research Group.
    5. Rodrigo Caputo & Felipe Liendo & Juan Pablo Medina, 2006. "New Keynesian Models For Chile During The Inflation Targeting Regime: A Structural Approach," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 9(3), pages 73-95, December.
    6. Rodrigo Caputo, 2004. "Exchange Rates, Inflation and Monetary Policy Objectives in Open Economies: The Experience of Chile," Econometric Society 2004 Latin American Meetings 298, Econometric Society.
    7. Mr. Eric Parrado, 2004. "Singapore's Unique Monetary Policy: How Does it Work?," IMF Working Papers 2004/010, International Monetary Fund.
    8. Rodrigo Caputo, 2009. "External Shocks and Monetary Policy. Does it Pay to Respond to Exchange Rate Desviations?," Revista de Analisis Economico – Economic Analysis Review, Universidad Alberto Hurtado/School of Economics and Business, vol. 24(1), pages 55-99, Junio.
    9. José De Gregorio R. / & Andrea Tokman R., 2005. "Fear of Floating and Exchange Rate Policy in Chile," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 8(3), pages 29-54, December.
    10. Macarena García & Pablo García & Bernardita Piedrabuena, 2005. "Fiscal and Monetary Policy Rules: The Recent Chilean Experience," Working Papers Central Bank of Chile 340, Central Bank of Chile.

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