SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: The performance of various monetary rules is investigated in an open economy with incomplete exchange rate pass-through. Implementing monetary policy through an exchange-rate augmented policy rule does not improve social welfare compared to using an optimized Taylor rule, irrespective of the degree of pass-through. However, an indirect exchange rate response, through a policy reaction to Consumer Price Index (CPI) inflation rather than to domestic inflation, is welfare enhancing in all pass-through cases. This result is moreover independent of whether society values domestic or CPI inflation stabilization. The only case where a direct real exchange rate response is slightly welfare improving occurs when the other reaction coefficients, on inflation and output, are sub-optimal.

Keywords: Exchange rate pass-through; monetary policy; simple policy rules; small open economy; Taylor rule

JEL-codes: E52; E58; F41

30 pages, October 31, 2001

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