Choices of Optimal Monetary Policy Instruments Under the Floating and the Basket-Peg Regimes

This paper determines whether adopting the basket-peg rather than the floating regime is optimal for emerging market countries. Under the basket-peg regime, there is a trade-off between practical usefulness and welfare losses associated with capital movements across countries. We develop a dynamic stochastic general equilibrium model for small open economies to derive a simple basket weight rule. Although this is suboptimal, we find it practical and easy to implement. With calibration using Singaporean and Thai data for 1997Q3-2006Q2 and comparison among cumulative losses associated with the policy instrument rules, we show that a commitment to the basket weight rule is superior to other instrument rules under the floating regime for small, open emerging market countries like Singapore and Thailand