Optimal Flexible Inflation Targeting, Interest-rate Smoothing and the Open Economy

Optimal monetary policy design in the context of a small open economy is studied in this paper. The monetary-policy design problem for the small open economy need not be isomorphic to the closed-economy problem. In this paper, the existence of endogenous deviations from the law of one price makes achieving the objectives of monetary policy a task fraught with compromises. The paper shows that, in such an economy, the interest-rate rule under pre-commitment is one that is forward and backward looking in terms of domestic and foreign technology shocks, and is intrinsically inertial. It also shows that the interest-rate rules that arise from discretion take the generic form of Taylor-type rules with CPI inflation as the measure of inflation. It is shown that if the central bank has the incentive to deviate from a commitment policy (a time-inconsistency problem), it may be optimal to delegate policy making to a central banker who has a taste for smoother interest-rate movements - an interest-rate conservative. The implied rule in that case is a Taylor-type rule where the instrument is in first-differences.