Evaluations of different monetary policy regimes for a small developing open economy

Motivated by recent experiences in Iran, this paper incorporates structural characteristics that reinforce the reluctance of central banks to commit to free floating exchange rates (‘fear of floating’) into optimal policy formulation to determine the extent of exchange rate involvement in monetary policy. We utilize a small stylized model of a small developing open economy calibrated for the Iranian economy to compare the performance of alternative policy regimes, namely flexible domestic inflation targeting, flexible consumer price index inflation targeting, and real exchange targeting in handling higher openness, higher exchange rate pass through, and financial vulnerability. Evaluation of the above alternative policy regimes and relative stability of key macroeconomic variables are conducted through an optimal Ramsey policy approach. The results suggest that, in financially vulnerable small open developing economies, consumer price IT may not be the optimal policy and giving a higher positive weight to the real exchange rate in the central bank’s loss function and allowing policy reaction to this variable via the instrument rate can result in a lower social loss and more stability for the key macroeconomic variables, and hence a superior policy regime. Policy evaluation results based both on stabilization and welfare measures obtained in this paper imply that for the developing commodity (oil) exporting economies with high degrees of financial vulnerability and relatively high pass-through rates, an IT policy framework in which the real exchange rate is also targeted is a superior regime.