Optimal Interest Rate Policy in a Small Open Economy

45 Pages Posted: 17 Jan 2002 Last revised: 24 Jan 2002

See all articles by Eric Parrado

Eric Parrado

Central Bank of Chile

Andrés Velasco

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Date Written: January 2002

Abstract

Using an optimizing model we derive the optimal monetary and exchange rate policy for a small stochastic open economy with imperfect competition and short run price rigidity. The optimal monetary policy has an exact closed-form solution and is obtained using the utility function of the representative home agent as welfare criterion. The optimal policy depends on the source of stochastic disturbances affecting the economy, much as in the literature pioneered by Poole (1970). Optimal monetary policy reacts to domestic and foreign disturbances. If the intertemporal elasticity of substitution in consumption is less than one, as is likely to be the case empirically, the optimal exchange rate policy implies a dirty float: interest rate shocks from abroad are met partially by adjusting home interest rates, and partially by allowing the exchange rate to move. This optimal pattern may help rationalize the observed fear of floating.

Suggested Citation

Parrado, Eric and Velasco, Andrés, Optimal Interest Rate Policy in a Small Open Economy (January 2002). NBER Working Paper No. w8721. Available at SSRN: https://ssrn.com/abstract=297347

Eric Parrado

Central Bank of Chile ( email )

Agustinas 1180
Santiago
Chile

Andrés Velasco (Contact Author)

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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