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

Abstract: The central bank’s optimal objective function is analyzed in a small open economy model allowing for incomplete exchange rate pass-through. The results indicate that social welfare can only be marginally improved by including an explicit exchange-rate term in the delegated objective function, irrespective of the degree of pass-through. An implicit response to the exchange rate, through Consumer Price Index (CPI) inflation targeting is, however, beneficial. Welfare can, moreover, be enhanced by appointing a central banker with a greater preference for interest rate smoothing than that of the society, as a result of surpassing some of the stabilization bias arising under a discretionary policy. Consequently, there are welfare gains from monetary policy inertia. The optimal degree of interest rate smoothing is increasing in the degree of pass-through.

Keywords: Exchange rate pass-through; inflation targeting; interest rate inertia; monetary policy; small open economy

JEL-codes: E52; E58; F41

37 pages, October 31, 2001

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