The Choice of Monetary Policy Regime for Small Open Economies

Inflation targeting and exchange rate targeting, including monetary union, are analyzed in a simple, estimated macroeconomic model of a small open economy. Flexible inflation targeting produces lower nominal and real variability than exchange rate targeting because the latter gives rise to persistent oscillations in the real interest rate and the real exchange rate due to the 'Walters' effect'. We find, however, that with commitment to simple instrument rules, the performance of flexible inflation targeting can almost be matched.