The paper develops a New Keynesian Small Open Economy Model charac- terized by external habit formation and Calvo price setting with dynamic in‡ation updating. The model is used to analyze the e¤ect of nominal ex- change rate targeting on optimal policy and impulse responses. It is found that even moderate exchange rate concerns are capable of changing both sign and magnitude of the optimal instrument response to variables, and that whether the concern is with respect to the level or …rst di¤erence has much impact on monetary policy. Also, the cost of exchange rate stabilization in terms of output and in‡ation is evident in the model, and impulse responses under moderate exchange rate targeting are not simple combinations of those under a ‡oat and a regime that cares almost only for meeting the exchange rate target.
