DP220 | On Optimal Stabilization Policy and Nominal Income Targets in an Open Economy

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This paper considers optimal stabilization policy and nominal income targets for an open economy where the authorities are concerned both with unemployment and monetary instability. To fully achieve these two objectives the authorities must use both monetary and "supply-side" fiscal policy. It is shown that there is an optimal assignment of monetary policy to the monetary stability objective, and supply-side fiscal policy to the unemployment objective. In a second-best world, where only monetary policy can be used in the short run, there is an optimal exchange rate rule, which balances the welfare cost of unemployment against that of monetary instability. This rule prescribes appreciations of the exchange rate following domestic supply shocks and external price and interest rate shocks. Domestic money demand shocks do not, however, necessitate a change in the exchange rate. The analysis suggests that nominal income targets are an optimal policy only if supply and world interest rate shocks do not occur. Alternatively, they are optimal if monetary stability carries no weight in the policy-makers' objective function and fiscal policy can be directed against supply shocks.