Estimating Central Bank preferences in a small open economy: Sweden 1995-2009

Interest Rate rules are often estimated as simple reaction functions linking the policy interest rate to variables such as (forecasted) inflation and the output gap; however, the coefficients estimated with this approach are convolutions of structural and preference parameters. I propose an approach to estimate Central Bank preferences starting from the Central Bank's optimization problem within a small open economy. When we consider open economies in a regime of Inflation Targeting, the issue of the role of the exchange rate in the Monetary Policy rule becomes relevant. The empirical analysis is conducted on Sweden, to verify whether the recent stabilization of the Krona/Euro exchange rate was due to “Fear of Floating”; the results show that the exchange rate might not have played a role in monetary policy, suggesting that the stabilization probably occurred as a result of increased economic integration and business cycle convergence.