International Interest Rate Shocks and Monetary Policy in a Small Open Economy

Considering that a significant part of business cycle fluctuations in small open economiescould be explained by international interest rate shocks, this paper attempts to characterizethe monetary policy rule that is optimal among simple and implementable rules for aneconomy where international interest rate shocks work as main sources of business cycles. Forthis purpose, the performances of various monetary policy rules are compared in terms ofsocial welfare based on a standard small open economy model. The main findings of thispaper are as follows. First, for a small open economy vulnerable to international interest rateshocks, domestic goods price inflation targeting is the optimal policy rule within a family ofsimple and implementable monetary policy rules. Second, it is found that exchange ratefluctuations implied by inflation targeting rule expose the monetary authority to a trade-offbetween total demand stabilization and increased volatility of inflation. KCI Citation Count: 0