Working Paper

Monetary stabilization policy in an open economy

Abstract: This paper investigates optimal stabilization policy in a small open economy using a continuous time model in which inflation depends on future monetary policy as well as past inflation. The impact of monetary policy is assumed to operate via real interest rates and the real exchange rate and the setting of real interest rates is chosen so as to minimize quadratic costs of fluctuations in output and inflation, subject to varying expectations in the foreign exchange market. Analytical expressions and simulation results are presented for \"time inconsistent\" optimal policy, the \"dynamic programming\" solution, for policy which ignores the exchange rate effects when setting real interest rates, and for the \"optimal linear feedback\" rule.

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 1985

Number: 262