Monetary Policy in a Small Open Economy with Imperfect Pass-Through

  • Mohamed DouchEmail author


This paper studies the stabilization and welfare properties of various monetary policy regimes in a tractable framework suitable for the analysis of monetary policy in a small open economy environment with imperfect pass-through and inflation indexation. Using welfare criteria to evaluate the best monetary policy, results show that price-level targeting performs well and provides an alternative method for conducting successful monetary policy in the case of a small-open economy. Benefits of price-level targeting rules noted in the literature for closed economies also translate to the small open economy setting once allowing for the combination of inflation inertia and exchange rate imperfect pass-through. As the exchange rate is an important element of the transmission of monetary policy, movements in these variable and other foreign variables often account for a significant part of the variation in the consumer price index via their direct effect on the price of imported goods. Imperfect exchange rate pass-through favors the choice of price-level targeting over consumer price index inflation targeting.


Small-open economy Monetary policy Inflation targeting Price level targeting Exchange rate imperfect pass-through 


E31 E52 E58 


Supplementary material

11293_2019_9646_MOESM1_ESM.docx (945 kb)
ESM 1 (DOCX 945 kb)


  1. Ambler, S. (2014). Price-level targeting: a post mortem?. C.D. Howe Institute, Commentary No. 400. Available online at:
  2. Bailliu, J., Meh, C., & Zhang, Y. (2015). Macroprudential rules and monetary policy when financial frictions matter. Economic Modelling, 50, 148–161.CrossRefGoogle Scholar
  3. Batini, N., & Yates, A. (2003). Hybrid inflation and price level targeting. Journal of Money, Credit and Banking, 35, 283–300.CrossRefGoogle Scholar
  4. Calvo, G. (1983). Staggered prices in a utility maximizing framework. Journal of Monetary Economics, 12, 383–398.CrossRefGoogle Scholar
  5. Campa, J., & Goldberg, L. S. (2005). Exchange rate pass through into import prices. Review of Economics and Statistics, 87(4), 679–690.CrossRefGoogle Scholar
  6. Christiano, L. J., Eichenbaum, M., & Evans, C. L. (2005). Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy, 113(1), 1–45.CrossRefGoogle Scholar
  7. Clarida, R., Galí, J., & Gertler, M. (2000). Monetary policy rules and macroeconomic stability: Evidence and some theory. Quarterly Journal of Economics, 115(1), 147–180.CrossRefGoogle Scholar
  8. Clarida, R., Galí, J., & Gertler, M. (2002). A simple framework for international monetary policy analysis. Journal of Monetary Economics, 49(5), 879–904.CrossRefGoogle Scholar
  9. Devereux, M., Lane, P., & Xu, J. (2006). Exchange rates and monetary policyin emerging market economies. The Economic Journal, 116(511), 478–506.CrossRefGoogle Scholar
  10. Douch, M., & Essaddam, N. (2010). Monetary policy conduct: A hybrid framework. Journal of Economics and International Finance, 2(7), 119–137.Google Scholar
  11. Erceg, C. J., Henderson, D. W., & Levine, A. T. (2000). Optimal monetary policy with staggered wage and price contracts. Journal of Monetary Economics, 46, 281–313.CrossRefGoogle Scholar
  12. Flamini, A. (2005). Inflation targeting and exchange rate pass-through. Graduate Institute of International Studies, HEI working paper no: 04/2004. Available at:
  13. Fuhrer, J. C., & Moore, G. R. (1995). Inflation persistence. Quarterly Journal of Economics, 111(1), 127–159.CrossRefGoogle Scholar
  14. Galí, J., & Monacelli, T. (2005). Monetary policy and exchange rate volatility in a small open economy. The Review of Economic Studies, 72(3), 1–28.CrossRefGoogle Scholar
  15. Goodfriend, M. S., & King, R. G. (2001). “The case for price stability,” in ‘why price stability?’. In Proceedings of the ECB first ECB central banking conference (pp. 53–94). Frankfurt am Main: Frankfurt European Central Bank. Also available as NBER working paper, no 8423. Available at: Scholar
  16. Hatcher, M., & Minford, P. (2016). Stabilisation policy, rational expectations and price-level versus inflation targeting: A survey. Journal of Economic Surveys, 30(2), 327–355.CrossRefGoogle Scholar
  17. Justiniano, A., & Preston, B. (2010). Monetary policy and uncertainty in an empirical small open-economy model. Journal of Applied Econometrics, 25(1), 93–128.CrossRefGoogle Scholar
  18. Kollmann, R. (2002). Monetary policy rules in the open economy: Effects on welfare and business cycles. Journal of Monetary Economics, 49(5), 989–1015.CrossRefGoogle Scholar
  19. Leith, C., & Malley, J. (2007). Estimated open economy new Keynisian Phillips curves for the G7. Open Economies Review, 18(4), 405–426.CrossRefGoogle Scholar
  20. Mishkin, F. S., & Schmidt-Hebbel, K. (2002). One decade of inflation targeting in the world: What do we know and what do we need to know? In N. Loayza & R. Soto (Eds.), Inflation targeting: Design, performance, challenges (pp. 171–219). Santiago: Central Bank of Chile.Google Scholar
  21. Rabanal, P., & Rubio-Ramírez, J. (2005). Comparing new Keynesian models of the business cycle: A Bayesian approach. Journal of Monetary Economics, vol., 52(6), 1151–1166.CrossRefGoogle Scholar
  22. Røisland, Ø. (2006). Inflation inertia and the optimal hybrid inflation/price-level target. Journal of Money, Credit and Banking, 38(8), 2247–2251.CrossRefGoogle Scholar
  23. Rubio, M., & Carrasco-Gallego, J. A. (2014). Macroprudential and monetary policies: Implications for financial stability and welfare. Journal of Banking and Finance, 49(C), 326–336.CrossRefGoogle Scholar
  24. Sahuc, J. G. (2004). Partial indexation and inflation dynamics: What do the data say. Applied Economics Letters, 11(13), 827–832.CrossRefGoogle Scholar
  25. Smets, F., & Wouters, R. (2003). An estimated stochastic dynamic general equilibrium model of the euro area. Journal of the European Economic Association, 1, 1123–1175.CrossRefGoogle Scholar
  26. Taylor, J. B. (1993). Macroeconomic policy in a world economy: From econometric design to practical operation. New York: W W Norton.Google Scholar
  27. Taylor, J. B. (1999). A historical analysis of monetary policy rules. In J. B. Taylor (Ed.), Monetary policy rules. Chicago: University of Chicago Press.CrossRefGoogle Scholar
  28. Woodford, M. (2003). Interest and prices: Foundations of a theory of monetary policy. Princeton University Press: Princeton.Google Scholar
  29. Yun, T. (1996). Monetary policy, nominal price rigidity, and business cycles. Journal of Monetary Economics, 37, 345–370.CrossRefGoogle Scholar

Copyright information

© International Atlantic Economic Society 2020

Authors and Affiliations

  1. 1.Political Science and Economics DepartmentRoyal Military College of CanadaKingstonCanada

Personalised recommendations