Optimum Monetary Instrument Option in the Case of a Small Open Economy

This essay examines the choice of monetary policy instrument for a small open economy under flexible exchange rate regime with some reference to Indonesia. To approach the issue a simple ad-hoc aggregate supply-IS-LM model is used for the analysis. Although basically the issue concerning monetary instrument problem tend to be more empirical rather than theoretical, this essay argues that some rules of thumb could still be drawn from the analysis of the theoretical model to solve the problem. The recognition of the true behavioural relationship among aggregate variables in the economy is important as guidance for the optimal policy rule. The analysis also recognises that a credible commitment from the monetary authority towards the instrument chosen is important.