Alternative Monetary Rules for a Small Open Economy: The Case of Canada
I compare the performance of alternative monetary rules for Canada using an open economy model under incomplete markets. Different rules generate different paths for the markup and the terms of trade. A comparison of welfare levels suggests that flexible inflation targeting, the Bank of Canadaês current policy, dominates strict targeting rules³among which a fixed exchange rate with the U.S.³and the Taylor rule. In contrast to other studies, strict targeting rules generate a more stable real economy by stabilizing markup dynamics. Flexible inflation targeting dominates because it yields a positive covariance between consumption and the labor effort, which provides agents with a source of risk diversification.
Fixed exchange rates; Inflation targeting; Monetary rules; Taylor rule; Welfare
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