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

In: Inflation Targeting: Desing, Performance, Challenges

  • Eric Parrado

    (Ministerio de Hacienda, Gobierno de Chile)

  • Andrés Velasco

    (Ministerio de Hacienda, Gobierno de Chile)

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.

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This chapter was published in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.) Inflation Targeting: Desing, Performance, Challenges, , chapter 7, pages 295-348, 2002.
This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v05c07pp295-348.
Handle: RePEc:chb:bcchsb:v05c07pp295-348
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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  2. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
  3. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
  4. Mario Blejer & Alfredo Leone & Pau Rabanal & Gerd Schwartz, 2002. "Inflation Targeting in the Context of IMF-Supported Adjustment Programs," 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 10, pages 439-464 Central Bank of Chile.
  5. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
  6. Eric Parrado & Andres Velasco, 2002. "Optimal Interest Rate Policy in a Small Open Economy," NBER Working Papers 8721, National Bureau of Economic Research, Inc.
  7. Svensson, Lars E O, 1998. "Open-Economy Inflation Targeting," CEPR Discussion Papers 1989, C.E.P.R. Discussion Papers.
  8. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
  9. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June.
  10. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," Working Papers 97-32, C.V. Starr Center for Applied Economics, New York University.
  11. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 04/21, International Monetary Fund.
  12. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  13. Ben S. Bernanke & Julio J. Rotemberg, 1997. "NBER Macroeconomics Annual 1997, Volume 12," NBER Books, National Bureau of Economic Research, Inc, number bern97-1, January.
  14. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  15. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
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