Monetary Policy and Welfare in a Small Open Economy

This paper characterizes welfare in a small open economy and derives the correspondingoptimal monetary policy rule. It shows that the utility-based loss function for a small openeconomy is a quadratic expression in domestic inflation, output gap and real exchange rate. Incontrast 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 closedeconomy and does not prescribe a pure floating exchange rate regime. Domestic inflationtargeting is optimal only under a particular parameterization, where the unique relevantdistortion in the economy is price stickiness. Under a general specification for preferencesand in the presence of inefficient steady state output, exchange rate targeting arises as part ofthe optimal monetary plan.