Essays on monetary policy for a small open economy

This dissertation analyses the design of monetary policy rules for small open economies, with special emphasis on the role played by the real exchange rate.; The first chapter develops a model with several exchange rate channels of transmission for monetary policy. The model implies that the openness of the economy has a direct effect on the social welfare objective, and that the optimal policy rule differs from that which obtains in a closed economy. Any variation in the interest rate leads, through the real exchange rate, to movements in the firms' real marginal cost in the opposite direction. As a result, the implied optimal monetary policy regime is a domestic (or producer) inflation target coupled with a controlled floating of the exchange rate.; The second chapter evaluates the consequences of a central bank stabilizing alternative measures of inflation in a small open economy. Simulations show that policy rules derived from private agents' optimizing behavior perform better than alternative monetary policy arrangements. Within each targeting regime, commitment of the monetary authority yields the smallest welfare loss. The appropriate policy regime for a typical open economy is producer price inflation (PPI) target. Contrary to central bank practices, a consumer price inflation (CPI) target should be considered only by highly open economies.; The third chapter provides empirical evidence on cross-country monetary policy rules for the major OECD countries during 1979Q2 to 1998Q4 period. The empirical results point to a convergence of monetary policy practices in the post-1987Q3 period, with economies moving towards a strict anti-inflation policy. From 1979Q3 to 1987Q2, there is evidence of a passive or accommodative monetary policy. Comparing the performance of alternative measures of inflation, PPI appears to have played an implicit role of target inflation rate in the latter period. For individual countries, evidence of an implicit PPI inflation target is strongly correlated with a more stable real exchange rate. Such a policy avoids unnecessary fluctuations in the nominal interest rate, which only reacts to disturbances that affect domestic variables.