Central bank learning, terms of trade shocks and currency risk: Should only inflation matter for monetary policy?

This paper examines the role of interest rate policy in a small open economy, subject to terms of trade shocks and time-varying currency risks. The private sector makes optimal decisions in an intertemporal, non-linear setting with rational, forward-looking expectations. In contrast, the monetary authority chooses an optimal interest rate reaction function, given a loss function that is conditional on the state of the economy and given its “least squares learning” about the evolution of inflation and exchange-rate depreciation. The simulation results of the effects of different policy scenarios on welfare show that, on balance, the preferred stance should be strict inflation targeting.