Central Bank Preferences, Distribution Forecasts and Economic Stability in a Small Open-economy

This paper relates the central bank's preferences on the inflation index and on the degree of smoothness of the interest rate to the quality of its forecasts and the expected perturbing impact of several shocks. The framework is a Markov jump-linear-quadratic system for optimal policy with model uncertainty in a timeless perspective. Comparing CPI and domestic inflation targeting, the latter implies considerably less variability in the distribution forecast of the economic dynamics. Furthermore, domestic inflation targeting stands out for much less sensitiveness to interest rate smoothing, and for resulting in more expected economic stability. Importantly, domestic inflation targeting allows significantly improving the prediction accuracy of the interest rate behaviour.