Effects of Optimal Monetary Policy Rules on Welfare in a Small Open Economy: A Simulation Analysis
Dr. Muhammad Tariq Mahmood, Dr. Sadaf Shahab

Abstract
This study explores the optimal monetary policy reaction function and its consequences on social welfare, considering an emerging open economy. Our analysis finds that due to discretionary policy the central bank faces price and exchange rate puzzles and does not care about macroeconomic condition. This analysis shows that with discretion the benefit of policy do not accrue to the society, as predicted, rather the central bank’s stance followed during the period of study has not helped in declining inflation. Under discretion the exchange rate channel is not significant. A Monte Carlo simulation experiment indicates that rules perform better in an open economy using Pakistan’s data. If central banks of an emerging economy follow a rule based monetary policy, it will help the economic agents to form expectations regarding investment, consumption and other decision. Thus, it is plausible that central bank should adopt any rule, particularly when it is working in an open economy. We also find that following an open economy rule a liberal target of inflation would work better than the strict target, perhaps due to higher average rate of inflation and openness to national and international shocks. The relationship of variance of interest rate with output variance is almost linear, while with other two variables is non-linear. This result emphasizes that the choice of rule rests in the hands of monetary authorities.

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