Monetary Policy, Exchange Rate Flexibility and Exchange Rate Pass-through *

Abstract

This paper develops a dynamic general equilibrium model of a small open economy to investigate alternative monetary rules, differing primarily in the degree to which they allow for exchange rate flexibility. A central argument of the paper is that the nature of the trade-off betweenfixed' andfloating' exchange rates may be quite different in mature industrial economies than in emerging market economies. The critical distinction is the degree to which movements in the exchange rate pass- through to domestic consumer prices. With very high exchange rate pass-through, all monetary rules face a significant trade-off between output (or consumption) volatility and the volatility of inflation. Policies which stabilize output require high exchange rate volatility which implies high inflation volatility. But with limited or delayed pass- through, this trade-off is much less pronounced. A flexible exchange rate policy which stabilizes output can do so without high inflation volatility. In addition, we argue that the best monetary policy rule in an open economy is one which stabilizes non-traded goods price inflation. Finally, we show that a policy of strict inflation targeting is much more desirable in an economy with limited pass-through.

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