Alternative Monetary Rules in the Open-Economy: a Welfare-Based Approach

Using an optimizing model we compare alternative monetary policy rules and exchange rate regimes for a small stochastic open economy with imperfect competition and short run price rigidity. The criteria to choose among rules and regimes are obtained using a welfare criterion derived from the utility function of the representative agent. The main findings of this paper are that, depending on what shocks affect this economy, the effects of inflation targeting on output and inflation volatility depend crucially on the exchange rate regime and the inflation index being targeted. With regard to the exchange rate, we find that the loss in agents’ welfare is much higher under managed exchange rates than under flexible rates in presence of real shocks, while for nominal shocks the reverse is true. As far as the definition of inflation targeting index is concerned, domestic inflation appears to outperform the CPI. Finally, flexible inflation targeting is welfare superior to strict targeting.