Description

In a small economy, with complete markets and domestic price stickiness, a monetary policy rule that reacts to domestic inflation implements the efficient allocation, as long as it also reacts to the natural rate of interest. In this case, a policy response to the exchange rate or any other foreign variable is inefficient. We show that, when the central bank is unable to observe the natural rate of interest, a domestic inflation targeting rule that reacts also to the real exchange rate is optimal. This rule is able to fully stabilize domestic inflation and, at the same time, induce efficient movements in relative prices (terms of trade) through nominal devaluations. Indeterminacy can arise, but a stronger policy response to domestic inflation can prevent this from happening.