Discretionary policy in a small open economy: Exchange rate regimes and multiple equilibria

We study a Markov-perfect monetary policy in an open New Keynesian economy with incomplete financial markets. We analyze inflation and exchange rate targeting regimes and demonstrate that both cases may result in multiple equilibria. These equilibria feature qualitatively and quantitatively different economic dynamics following the same shock. The model can help us to understand sudden changes in the interest rate and exchange rate volatility in 'tranquil' and 'volatile' times under a fully credible 'soft peg' of the nominal exchange rate.