Macroeconomic trade-offs in small open economies

Abstract

[ACCESS RESTRICTED TO THE UNIVERSITY OF MISSOURI AT REQUEST OF AUTHOR.] This paper addresses the issue of output gap, inflation and exchange rate trade-offs in small open economies. The weights imposed on output gap, inflation rate and exchange rate in the policy objective function are estimated to examine two scenarios: First, an inflation-targeting country will gain the credibility bonus under a precommitment policy and have a favorable output-inflation tradeoff. Second, a country with a linked fixed exchange rate regime is relatively more concerned about exchange rate stabilization and imposes a greater weight on the exchange rate. We choose New Zealand, Hong Kong and Singapore as the analytic examples. The estimation results from Generalized Method of Moments and Ordinary Least Squares support our second intuition, but bring about a discussion of nominal rigidity and credibility gains under inflation targeting.