Estimating monetary policy rules in small open economies

This paper presents an approach for empirically estimating long-run monetary policy rules in small open economies. The approach utilizes the cointegrated VAR methodology and statistical tests on long- and short-run relations, and investigates policy responses. An application is presented for the case of Trinidad and Tobago. The analysis reveals an empirically supported long-run monetary policy rule for the nominal exchange rate, and provides empirical evidence that oil price shocks are transmitted through the TT economy in part via the effects on US prices. Dynamic specification of the nominal exchange rate reveals significant adjustment towards the target equilibrium level, and significant effects from foreign and domestic variables save for the exchange rate. Forecast analysis reveals the significance of oil-price forecasts, and forecast-errors, on monetary policy. The parsimonious model and its parameter estimates are empirically constant and generate reliable forecasts that provide important implications for using estimated policy rules.