Managing Macroeconomic Fluctuations with Flexible Exchange Rate Targeting

We show that a monetary policy rule that uses the exchange rate to stabilize the economy outperforms a Taylor rule in managing macroeconomics fluctuations and in achieving higher welfare. The differences between the rules are driven by: (i) the path of the nominal exchange rate and interest rate under each rule, and (ii) time variation in the risk premium, which leads to deviations from uncovered interest parity. These differences are larger in very open economies, more exposed to foreign shocks, and in which domestic and foreign goods are highly substitutable.