ERIA-DP-2011-09 ERIA Discussion Paper Series Foreign Output Shocks and Monetary Policy Regimes in Small Open Economies: A DSGE Evaluation of East Asia Joseph D. ALBA  Nanyang Technological University, Singapore Wai-Mun CHIA Nanyang Technological University, Singapore Donghyun PARK Asian Development Bank (ADB), The Philippines December 2011 Abstract: East Asia’s small open economies were hit in varying degrees by the sharp drop in the output of major industrial countries during the global financial and economic crisis of 2008-2009. This highlights the role of monetary policy regimes in cushioning small open economies from adverse external output shocks. To assess the welfare impact of external shocks on key macroeconomic variables under different monetary policy regimes, we numerically solve and calculate the welfare loss function of a dynamic stochastic general equilibrium (DSGE) model. We find that CPI inflation targeting minimizes welfare losses for import-to-GDP ratios from 0.3 to 0.9. However, welfare under the pegged exchange rate regime is almost equivalent to CPI inflation targeting when the import-to-GDP ratio is one while the Taylor-type rule minimizes welfare when the import-to-GDP ratio is 0.1. We calibrate the model and derive welfare implications for eight East Asian small open economies. Keywords: Trade channel, Import-to-GDP ratio, small open economies, welfare, exchange rate regimes, inflation targeting, Taylor rule, foreign output shock. JEL Classification: F40, F41, E52, F31  Corresponding author, Division of Economics, School of Humanities and Social Sciences, Nanyang Technological University, 14 Nanyang Drive, Singapore 637332; Tel: (65) 6790–6234; Fax: (65) 6795–5797; E–mail: ajoalba@ntu.edu.sg