Considering that a significant part of business cycle fluctuations in small open economies
could be explained by international interest rate shocks, this paper attempts to characterize
the monetary policy rule that is optimal among simple and implementable rules for an
economy where international interest rate shocks work as main sources of business cycles. For
this purpose, the performances of various monetary policy rules are compared in terms of
social welfare based on a standard small open economy model. The main findings of this
paper are as follows. First, for a small open economy vulnerable to international interest rate
shocks, domestic goods price inflation targeting is the optimal policy rule within a family of
simple and implementable monetary policy rules. Second, it is found that exchange rate
fluctuations implied by inflation targeting rule expose the monetary authority to a trade-off
between total demand stabilization and increased volatility of inflation.