Optimal Taylor Rules in an Estimated Model of a Small Open Economy

Abstract

The authors compute welfare-maximizing Taylor rules in a dynamic general-equilibrium model of a small open economy. The model includes three types of nominal rigidities (domestic-goods prices, imported-goods prices, and wages) and eight different structural shocks. The authors estimate the model's structural parameters by maximum likelihood using Canadian and U.S. data, and use a second-order approximation of the model to measure the welfare effects of different Taylor rules. By estimating the model, the authors can compare welfare levels with that attainable under the Taylor rule estimated for their sample period. They find that the welfare gains from moving to the optimal Taylor rule are larger than those obtained by previous researchers.Economic models; Exchange rates; Inflation targets