Assessing Monetary Policy Targeting Regimes for Small Open Economies

Abstract

This paper quantifies the performance of five monetary policy regimes in controlling macroeconomic volatility triggered by a variety of supply, demand and external shocks in small open economies. While the proposed macroeconomic model is generic, the application is to the case of Sri Lanka. The investigated regimes separately target the exchange rate, a monetary aggregate, nominal GDP, the CPI inflation rate and a Taylor composite of output gaps and inflation. The results suggest that inflation targeting offers the least macro-economic volatility overall. Consistent with earlier research and Mundell’s financial trilemma, its stabilising power is greatest under demand and external shocks, which have grown more prominent as product and financial markets have opened.

Keywords: Macroeconomic volatility, Monetary policy, Mundell’s trilemma, Sri Lanka

JEL Classification: E47, E52, N15