Commitment, Discretion and Fixed Exchange Rates in an Open Economy

Within a small open economy we derive a tractable framework for the analysis
of the optimal monetary policy design problem as well as of simple feedback
rules. The international relative price channel is emphasized as the one peculiar
to the open economy dimension of monetary policy. Hence flexibility in
the nominal exchange rate enhances such channel. We first show that a feature
of the optimal policy under commitment, unlike the one under discretion,
is to entail stationary nominal exchange rate and price level. We show that
this property characterizes also a regime of fixed exchange rates. Hence, in
evaluating the desirability of such a regime, this benefit needs to be weighed
against the cost of excess smoothness in the terms of trade. We show that
there exist combinations of the parameter values that make a regime of fixed
exchange rates more desirable than the discretionary optimal policy. When the
economy is sufficiently open, this happens for a high relative weight assigned to
output gap variability in the Central Bank's loss function and for high values of
the elasticity substitution between domestic and foreign goods. We draw from
this interesting conclusions for a modern version of the optimal currency area
literature.