Monetary policy and welfare in a small open economy

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.