Should Central Banks of Small Open Economies Respond to Exchange Rate Fluctuations? The Case of South Africa

We estimate a New Keynesian small open economy DSGE model for South Africa, using Bayesian techniques. The model features imperfect competition, incomplete asset markets, partial exchange rate pass-through, and other commonly used nominal and real rigidities, such as sticky prices, price indexation and habit formation. We study the e¤ects of various shocks on macroeconomic variables, and calculate the optimal Taylor rule coe ¢ cients using a loss function for the central bank. We \u85nd that the optimal Taylor rule places a heavier weight on ination and output than the estimated Taylor rule, but almost no weight on the devaluation rate of currency