Optimal Simple Targeting Rules for Small Open Economies

Abstract

This paper solves for optimal policy rules in a stylized small open economy model under a spectrum of targeting regimes. These policy reaction functions are presented as feedback rules highlighting the dominant state variables in each rule. Optimal simple rules - rules that exploit a reduced information set - are explored to assess how much is lost when information is excluded from the optimal state-contingent rule. For the model analyzed we find that some optimal simple rules can approximate reasonably well the optimal state-contingent rule, these simple rules contain the real exchange rate. Knowing which variables underpin the performance of the optimal state-contingent rule is important for developing simple, robust, rules with good stabilizing properties.

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