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Uncertain potential output: implications for monetary policy in small open economy

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  • Traficante, Guido

Abstract

A huge literature analyzes the performance of simple rules in closed-economy models when the policy-maker observes only a noisy measure of the state of the economy. This paper extends the analysis to a small-open economy new keynesian model. Passing from a closed-economy model to an open-economy one, there is another simple policy rule available to the central bank, namely the exchange rate peg. Hence, evaluating the performance of simple rules allows us to assess if the choice of the exchange rate regime depends on the uncertainty about the true state of the economy. Evaluating the conduct of monetary policy in terms of a Taylor rule, this paper shows that not reacting to the exchange rate yields better outcomes in terms of a standard loss function and quantifies for which parameter configuration in terms of the reaction to the exchange rate and the domestic inflation rate, the fixed exchange rate regime is to be preferred. The analysis is done both with complete and with incomplete information.

Suggested Citation

  • Traficante, Guido, 2012. "Uncertain potential output: implications for monetary policy in small open economy," Dynare Working Papers 22, CEPREMAP.
  • Handle: RePEc:cpm:dynare:022
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    More about this item

    Keywords

    small open economy; exchange rate regime; monetary policy rules; uncertainty;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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