When should monetary policy target the exchange rate

This paper evaluates the welfare effect of simple (but not optimal) monetary targeting rules in a stochastic two-country open-economy model featuring producer price stickiness and imperfect competition. We point out specific cases when the central bank would prefer to stabilize the exchange rate rather than domestic producer prices as recommended by Obstfeld and Rogoff (2002b), Clarida et al. (2002) and Gali and Monacelli (2002). Our results suggest that an exchange rate peg is particularly desirable when the country is small and faces an elastic export demand curve. Unlike earlier contributions, we evaluate welfare using a second order approximation of the model’s structural equilibrium conditions as well as of the welfare function. JEL Classification: F41 F42 F5