Optimal foreign exchange-rate policy for a small open economy

This paper examines optimal exchange-rate policy for a small open economy which faces temporary and pemanent, real and nominal disturbances. It demonstrates that exchange-rate stabilization is desirable if most diturbances are nominal. If most disturbances are real, then stabilization should be greater: (1) the greater the fraction of exchange-rate variance accounted for by permanent disturbances; (2) the greater the information available to firms in setting the wage; (3) the greater the fraction of exchange-rate variance attributed to domestic productivity shocks compared with foreign relative price shocks; and (4) the more elastic is labor supply.