OPTIMAL GOVERNMENT FINANCE POLICY AND EXCHANGE-RATE MANAGEMENT IN A STOCHASTICALLY GROWING OPEN-ECONOMY

Optimal monetary policy is analyzed in a stochastic small open economy , consisting of risk averse representative agents. The analysis shows how optimal monetary policy should be directed toward an optimal inter est rate target. This target, which maximizes the intertemporal utilit y of the representative agent, is determined by balancing off the marg inal gains of a higher interest rate on increased growth and the futur e consumption it generates, against the marginal losses stemming from a reduction in the holdings of real money balances. The paper shows ho w an appropriately set monetary growth rate eliminates the need for co ntinuous intervention in the exchange market. Copyright (C) 1996 Elsev ier Science Ltd