Monetary Policy and Exchange Rates in Small Open Economies


Richard Dennis

FRBSF Economic Letter 2001-16 | May 25, 2001

Controlling inflation is a key concern of central bankers around the world. But how best to control inflation differs across countries according to their individual characteristics; for example, small open economies tend to import more goods as a percentage of GDP than larger, more closed, economies, such as the United States.

Controlling inflation is a key concern of central bankers around the world. But how best to control inflation differs across countries according to their individual characteristics; for example, small open economies tend to import more goods as a percentage of GDP than larger, more closed, economies, such as the United States. Recognizing this, several recent papers have sought to clarify how the ingredients for successful monetary policy in small open economies differ from those in larger, more closed, economies. Of particular interest are whether central banks in small open economies should respond to exchange rate movements and how the presence of policy channels operating through the exchange rate affects the policymaking process. This Economic Letter will explore this literature and summarize the role the exchange rate plays in small open economies. It will also spell out the arguments for and against policymakers responding to exchange rate movements when setting policy.

Effects of exchange rate movements

Exchange rates are key variables in small open economies. Movements in exchange rates directly influence the prices of goods that are traded in world markets. Imported goods are both purchased by consumers and used as inputs into the production process. As the economy’s exchange rate depreciates, the prices of imported consumption goods increase, directly raising the consumers’ price index. The price of imported intermediate inputs also rises, raising firms’ production costs. Higher production costs also tend to culminate in higher consumer prices, as firms attempt to pass on their higher costs to consumers through higher prices for their final product. On the real economy side, the level of the real exchange rate influences world demand for domestically produced goods. An appreciation of the real exchange rate leads to less demand for domestically produced goods, as both foreign and domestic consumers substitute cheaper foreign goods for more expensive domestic goods. Falling domestic demand leads to less pressure on prices to rise and may even lead to falling prices.

To target domestic inflation or consumer price inflation?

Where exchange rates are volatile, this volatility can feed into consumer prices through the direct effect of higher prices for consumer imports. Consequently, a strategy of targeting consumer price inflation may lead to considerable interest rate volatility, as policymakers attempt to neutralize the exchange rate’s impact on consumer prices. Interest rate and exchange rate volatility may, however, be damaging if they lead to swings in real output. Consequently, it is sometimes argued that small open economies should target a measure of inflation that excludes the prices of tradable goods, or that, at the very least, policymakers should look beyond exchange rate fluctuations when setting policy (Ball 1999). Of course targeting a measure of domestic inflation that excludes exchange rate effects is easier said than done: The prices of many goods are influenced by exchange rates, not just those that are physically traded in world markets.

But distinguishing between tradable and nontradable goods is relatively easy to do in simulation studies. Such studies do tend to find that targeting consumer price inflation can create considerable interest rate and exchange rate volatility (Svensson 2000, Dennis 2000), but so too can targeting inflation in nontradable goods. Large swings in interest rates and exchange rates are associated more with targeting inflation too closely than they are with the measure of inflation targeted. If policymakers are concerned about the real effects of policy and are consequently prepared to permit inflation to return to its target rate more slowly, then interest rate volatility and exchange rate volatility are naturally dampened. Only when policymakers target inflation to the virtual exclusion of everything else do important differences between targeting domestic inflation and targeting consumer price inflation arise (Ball 1999).

Should policymakers respond to the exchange rate?

Regardless of which measure of inflation is targeted, there is an important issue of whether central banks in small open economies should respond to exchange rate movements when setting short-term nominal interest rates. That is, if a central bank sets interest rates using a rule, would a rule that included some measure of the exchange rate produce better economic outcomes? Responding to exchange rate movements is, of course, very different from targeting the exchange rate. The latter makes the exchange rate a policy goal, whereas the former treats the exchange rate as one further piece of information to be weighed when setting interest rates. Expressed in this way, the answer seems obvious. Policymakers should respond to all information that helps them meet their policy goals and achieve better economic outcomes. If the exchange rate provides information that is timely and relevant, then policymakers should make full use of this information when they set interest rates. So, if it can produce better economic outcomes, why does responding to exchange rates raise any controversy?

The arguments against responding to exchange rate movements fall into two broad categories. In the first category, policymakers set interest rates using a set of variables, and these variables are also the driving forces behind exchange rate movements. Provided the central bank is efficiently using the information at its disposal, there is no additional value to be had from also responding to the exchange rate itself; the exchange rate contains no extra information. In the second category, policymakers’ incomplete understanding of how the economy operates is manifest in uncertainty about how the economy responds to exchange rate movements. This uncertainty can place policymakers in awkward situations in which they mistakenly respond in precisely the wrong way to exchange rate movements: tightening when they should be loosening and vice versa. Consequently, it is argued, the information value in exchange rate movements is in fact very low and a prudent approach would suggest that policymakers should ignore exchange rate movements and set policy on the basis of more reliable indicators.

Into the first category fall Clarida, et al. (2001) and Batini, et al. (2001). While these two papers differ greatly in their level of disaggregation and overall complexity, they arrive at similar conclusions. Provided policymakers implement a rule in which interest rates respond to expected future inflation there is no additional need (Clarida, et al. 2001), or very little additional need (Batini, et al. 2001), for interest rates also to respond to exchange rate movements. In effect, the expectation of future inflation encompasses the exchange rate, leaving little or no need for an additional response to exchange rate movements. Despite their results, neither paper suggests that policymakers should not respond to exchange rate movements in some way, shape, or form. In fact, in both models policymakers are responding to exchange rate movements. This response is not direct, but through the exchange rate’s effect on expected future inflation.

The papers by Leitemo and Söderström (2001) and Guender (2001) fall into the second category. Leitemo and Söderström (2001) argue that because we are uncertain about how exchange rates are determined, policy rules developed in the context of one exchange rate model may perform poorly if that model proves incorrect. For some exchange rate models it may be appropriate for policymakers to tighten in response to a depreciating exchange rate, whereas for others it may be appropriate to loosen. Not knowing the correct exchange rate equation can result in policymakers loosening when they should be tightening and vice versa. The consequence can be excessive interest rate and exchange rate volatility that can easily be avoided through simply not responding to direct movements in exchange rates. Guender (2001), in a closely related result, shows that uncertainty about whether to tighten or loosen in response to a depreciating exchange rate can occur even with the correct exchange rate equation. If there is uncertainty about other aspects of the economy, then policymakers may respond to exchange rate movements inappropriately, with the economy suffering as a result.

Wrapping up

So where does our discussion of these four papers take us? Collectively these studies underscore that whether the exchange rate provides important channels for monetary policy and whether it should feature in the policy rule are conceptually different issues. However, in the absence of model uncertainty, each of the four papers discussed suggests that including a measure of the exchange rate in the policy rule leads to economic outcomes that are better, or at least no worse, than if the exchange rate is ignored. In this respect these four papers are in agreement with Ball (1999), Svensson (2000), and Dennis (2000). However, once model uncertainty is introduced the issue becomes clouded and it may indeed be genuinely disadvantageous for policymakers to employ rules that contain the exchange rate. What is unclear, however, is whether the forms of uncertainty that lead to poor outcomes with rules based on exchange rates are themselves reasonable.

In summary then, small open economies that target inflation tend to target consumer price inflation. In principle, trying to set interest rates to offset the imported inflation component of the consumers’ price index can lead to considerable volatility in interest rates and exchange rates. In practice this volatility can be avoided by not targeting inflation too closely, that is, by eliminating deviations between inflation and its target rate gradually rather than trying to keep inflation at target period by period. Whether central banks in small open economies should apply rules that include some measure of the exchange rate remains open to debate. Exploiting information contained in exchange rate movements may lead to better economic outcomes. But these better outcomes may be hard to realize, and trying to do so may prove destructive, unless policymakers are confident of the economic environment in which they operate.

Richard Dennis


Ball, Laurence. 1999. “Policy Rules for Open Economies.” In Monetary Policy Rules, ed. J. Taylor. Chicago: University of Chicago Press.

Batini, Nicoletta, Richard Harrison, and Steven Millard. 2001. “Monetary Policy Rules for an Open Economy.” Bank of England Working Paper.

Clarida, Richard, Jordi Gal’, and Mark Gertler. 2001. “Optimal Monetary Policy in Open Versus Closed Economies: An Integrated Approach.” Universitat Pompeu Fabra Working Paper.

Dennis, Richard. 2000. “Optimal Simple Targeting Rules for Small Open Economies.” Federal Reserve Bank of San Francisco Working Paper No. 2000-20.

Guender, Alfred. 2001. “On Optimal Monetary Policy Rules and the Role of MCIs in the Open Economy.” University of Canterbury Discussion Paper 2001-03. (accessed May 14, 2001).

Leitemo, Kai, and Ulf Söderström. 2001. “Simple Monetary Policy Rules and Exchange Rate Uncertainty.” Sveriges Riksbank Working Paper. (accessed May 14, 2001).

Svensson, Lars. 2000. “Open-Economy Inflation Targeting.” Journal of International Economics 50, pp. 155-183.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Anita Todd and Karen Barnes. Permission to reprint portions of articles or whole articles must be obtained in writing. Please send editorial comments and requests for reprint permission to