Monetary Policy Regimes in Small Open Economies: The Case of Sri Lanka*

Abstract

This paper quantifies the performance of five alternative monetary policy regimes in controlling macro volatility in a small open, emerging economy. The effects of supply, demand and external shocks are analyzed using a generic structural macro model and Monte Carlo simulation, calibrated to the case of Sri Lanka. Investigated regimes separately target the exchange rate, monetary aggregates, nominal GDP, the consumer price index inflation rate and a Taylor composite of output gaps and inflation. The results suggest that nominal GDP targeting minimizes real GDP volatility, and when stabilizing economic welfare is the objective, volatility is minimized under inflation targeting and Taylor policy rules. The IT regime is most effective under demand and external shocks, which have grown more prominent as product and financial markets have opened.