In this paper I examine the properties of monetary, nominal income and exchange rate targets, as stabilization policies in an open economy. Perfect capital mobility and a wide variety of transitory random shocks is assumed. Nominal wages are assumed to have been set in advance of the realization of the shocks. None of these rules is in general sufficient to minimize the welfare cost of aggregate fluctuations, and none necessarily dominates all others. Under the assumption that monetary control is subject to random errors optimal policy implies reactions to all observable shocks, and is characterized by heavy exchange market intervention.
European Economic Review