Commitment, Discretion and Fixed Exchange Rates in an Open Economy

Within a small open economy we derive a tractable framework for the analysis of the optimal monetary policy design problem as well as of simple feedback rules. The international relative price channel is emphasized as the one peculiar to the open economy dimension of monetary policy. Hence flexibility in the nominal exchange rate enhances such channel. We first show that a feature of the optimal policy under commitment, unlike the one under discretion, is to entail stationary nominal exchange rate and price level. We show that this property characterizes also a regime of fixed exchange rates. Hence, in evaluating the desirability of such a regime, this benefit needs to be weighed against the cost of excess smoothness in the terms of trade. We show that there exist combinations of the parameter values that make a regime of fixed exchange rates more desirable than the discretionary optimal policy. When the economy is sufficiently open, this happens for a high relative weight assigned to output gap variability in the Central Bank’s loss function and for high values of the elasticity substitution between domestic and foreign goods. We draw from this interesting conclusions for a modern version of the optimal currency area literature.