Monetary policy and foreign exchange interventions in emerging small open economies

Abstract

Compared with developed countries, emerging small open economies (ESOEs) experience greater economic fluctuations, mostly driven by commodity price shocks, balance-sheet constraints, and procyclical fiscal policies. This paper examines how monetary and sterilized foreign exchange (FX) interventions affect welfare and economic stability in the ESOEs. Sterilized FX interventions consistently improve welfare in all monetary policy arrangements. Ignoring the output gap in Taylor-type interest rate rules leads to significant welfare costs, particularly in economies with high exposure to foreign markets. The combination of Friedman rule with FX intervention neutralizes money-financed fiscal deficit and foreign shocks, improves welfare by reducing economic volatility, and highlights the importance of coordinated monetary and FX policies to stabilize ESOEs.