This paper investigates the performance of various monetary rules in an open economy with incomplete exchange rate pass-through. Implementing monetary policy through an exchange rate augmented policy rule does not improve social welfare compared to using an optimized Taylor rule, irrespective of the degree of pass-through. A direct exchange rate response improves welfare only if the other reaction coefficients, on inflation and output, are sub-optimal. However, an indirect exchange rate response, through a policy reaction to Consumer Price Index (CPI) inflation rather than to domestic inflation, is welfare enhancing. This result is independent of whether society values domestic or CPI inflation stabilization.
Exchange rate pass-through monetary policy simple policy rules small open economy Taylor rule