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Monetary policy and welfare in a small open economy

  • Bianca De Paoli

This paper characterizes welfare in a small open economy and derives the corresponding optimal monetary policy rule. It shows that the utility-based loss function for a small open economy is a quadratic expression in domestic inflation, output gap and real exchange rate. In contrast to previous works, this paper demonstrates that welfare in a small open economy, completely integrated with the rest of the world, is affected by exchange rate variability. Consequently, the optimal policy in a small open economy is not isomorphic to a closed economy and does not prescribe a pure floating exchange rate regime. Domestic inflation targeting is optimal only under a particular parameterization, where the unique relevant distortion in the economy is price stickiness. Under a general specification for preferences and in the presence of inefficient steady state output, exchange rate targeting arises as part of the optimal monetary plan.

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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 19950.

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Length: 52 pages
Date of creation: May 2004
Date of revision:
Handle: RePEc:ehl:lserod:19950
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