Optimal monetary rule for a small, open and dollarized economy

This work ventures into an unexplored area of ​​monetary policy in Uruguay: the discussion of optimal monetary policy (the rule) in a context of exchange rate floating. To this end, we have proceeded, first, to “calibrate” a model for a small, open and dollarized economy. Secondly, the performance of the economy was analyzed under different monetary rules, considering different parameters of aversion to product fluctuations and inflation and taking into account the associated variance frontier. Finally, these variances have been compared with those that would arise from a simple rule, in the “Taylor rule” style, and from an exchange rate or devaluation goal. The results indicate that the optimality of the monetary rules, and the variances of the product and inflation associated with them, depends on the parameters of the loss function. In particular, and like what has been observed in other works at international level, the establishment of a relatively high weight to the inflation target (price stability) implies not only a greater variance of the product but also higher levels of inflation variability. The trade-off begins only when the product stabilization target weights 15 times more than inflation. On the other hand, the results of the study carried out indicate that the variances associated with devaluation objectives are considerably greater than those obtained within the framework of an inflation target policy. A policy of the “Taylor rule” generates greater variance than an inflation target supported by a forward looking rule that includes all the variables of the system, but exhibits lower levels of variability than that arising from a target exchange rate.

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