Inflation targeting, optimal monetary policy, and exchange rates rate rules in a small open economy

The first chapter provides a simple dynamic neo-keynesian model that can be used to analyze the impact of monetary policy with inflation targeting in a small open economy. This open economy is characterized by imperfect competition and short-run price rigidity in the non-tradable sector. The paper shows that the choice of the optimal exchange rate regime depends crucially on the source of stochastic disturbances. In terms of the variability of output gap, a flexible exchange rate dominates managed exchange rates in presence of domestic productivity shocks, real foreign shocks, and cost-push shocks. In most of the cases NT-inflation targeting is preferable to CPI-inflation targeting, because the former stabilizes more inflation, output gap, and the real exchange rate.; Using an optimizing model, the second chapter derives the optimal monetary and exchange rate policy for a small stochastic open economy with imperfect competition and short-run price rigidity. The optimal monetary policy has an exact closed-form solution, and is obtained using a welfare criterion derived from the utility function of the representative agent. The paper concludes that the optimal policy depends crucially on the source of stochastic disturbances affecting the economy. Specifically, the optimal monetary policy of this small open economy requires a positive correlation between, domestic and rest-of-the-world nominal interest rates. In addition, the domestic interest rate need not react before a productivity shock because output is demand determined in the short-run.; Finally, the third chapter characterizes and identifies the dynamic effects of shocks in monetary policy on Chilean macroeconomic variables. I use a structural VAR approach with non-recursive contemporaneous restrictions. First, consistent with the predictions of a stochastic rational expectations model, a domestic monetary contraction would imply an appreciation of the exchange rate and falls in prices, output, and real money balances. Second, the source of Chilean output and real exchange rate volatility is very similar to that identified in more developed countries: monetary policy explains a relatively small proportion of domestic output variability, but a large proportion of exchange rate fluctuations. Finally, foreign monetary policy innovations have very short-lived effects on domestic interest rates, but longer-lived effect on exchange rates.