A Comparison of Alternative Monetary Policy Regimes in a Small Dynamic Open-Economy Simulation Model

In this paper, the simulation properties of a small, dynamic, open-economy IS-LM-Aggregate Supply model are examined under a variety of alternative policy rule assumptions. These assumptions include rigid money stock, exchange rate and nominal income targets, as well as less rigid policy rules that recognize information limitations. The model that is used consists of four dynamic structural equations describing aggregate demand, aggregate supply, money demand and the exchange rate. The parameters are chosen on the basis of existing empirical macro-models. Price expectations are adaptive in the short run but fully consistent in the long run. The implications of transitory and permanent shocks, both domestic and foreign, for the choice of policy regime are analyzed in the context of the model. The paper also highlights the important role played by real exchange rate adjustment in achieving full equilibrium in the presence of permanent shocks. The results bear strong similarities to the cross-policy rankings found in theoretical rational expectations models.