Monetary Policy in a Small Open Economy with Imperfect Pass-Through

This paper studies the stabilization and welfare properties of various monetary policy regimes in a tractable framework suitable for the analysis of monetary policy in a small open economy environment with imperfect pass-through and inflation indexation. Using welfare criteria to evaluate the best monetary policy, results show that price-level targeting performs well and provides an alternative method for conducting successful monetary policy in the case of a small-open economy. Benefits of price-level targeting rules noted in the literature for closed economies also translate to the small open economy setting once allowing for the combination of inflation inertia and exchange rate imperfect pass-through. As the exchange rate is an important element of the transmission of monetary policy, movements in these variable and other foreign variables often account for a significant part of the variation in the consumer price index via their direct effect on the price of imported goods. Imperfect exchange rate pass-through favors the choice of price-level targeting over consumer price index inflation targeting.