Real Shocks, Credibility & Stabilization Policy in a Small Open Economy

Intermittent exchange rate instability and attendant high interest rates have led some observers to argue that there is need for an alternate monetary regime such as a currency board or official dollarization. Against this background, this paper compares the welfare costs of various stabilization policies for the Jamaican economy. The analytic framework used is a stochastic model of a small open economy based on micro-foundations. When calibrated to Jamaican data, the results suggest that policy regimes that allow for some flexibility in monetary policy are superior, in terms of welfare, to a currency board or the extreme of dollarization. Further, at low levels of inflation policy could shift towards a full fledge inflation-targeting regime. The results however rely on the critical assumption that the policy regime is credible. Thus whilst dollarization may be inferior, policy makers are still confronted with the issue of the credibility of their stabilization policies