The exchange rate and optimal monetary policy rules in open and developing economies: Some simple analytics

Using a simple, tractable model, this paper revisits and expands upon issues relating to optimal monetary policy rules (MPRs) in open economies. The optimality of the rule is explored through various specifications of a central bank loss function as it is the loss function that offers insight into central bank preferences. Many of the issues on this topic have centred on the role of the exchange rate: Is it optimal for the policy instrument to react to the exchange rate? What is the role of the exchange rate in a domestic inflation targeting vs CPI inflation targeting? Does a fear of floating have any bearing on the way optimal MPRs are constructed? While this paper is not empirical, the analysis is relevant for central banks in open and developing economies that face a choice between allowing exchange rates to float (and adopting an inflation targeting regime) and engaging in some degree of exchange rate fixity.