Department of Economics
New York University
19 W. 4th Street, 6th Floor
New York, NY 10012
NBER Working Papers and Publications
|January 2002||Optimal Interest Rate Policy in a Small Open Economy|
with Andres Velasco: w8721
Using an optimizing model we derive 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 the utility function of the representative home agent as welfare criterion. The optimal policy depends on the source of stochastic disturbances affecting the economy, much as in the literature pioneered by Poole (1970). Optimal monetary policy reacts to domestic and foreign disturbances. If the intertemporal elasticity of substitution in consumption is less than one, as is likely to be the case empirically, the optimal exchange rate policy implies a dirty float: interest rate shocks from abroad are met partially by adjusting home inter...