This paper extends the analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand, incorporating realistic lags in the transmission channels of monetary policy. It compares targeting of CPI and domestic inflation, strict and flexible inflation targeting, and inflation-targeting reaction functions with the Taylor rule. The optimal monetary policy response to various shocks is examined. Flexible CPI-inflation targeting is found to be successful in limiting the variability of CPI inflation, the output gap, and the real exchange rate. Counterintuitively, negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model provides limited support for a monetary conditions index (MCI) that combines the real exchange rate with a long real interest rate and expected future values, rather than current values. The MCI is not directly observable or verifiable to external observers.This paper extends the analysis of closed-economy inflation targeting to a small open economy with forward-looking aggregate supply and demand, incorporating realistic lags in the transmission channels of monetary policy. It compares targeting of CPI and domestic inflation, strict and flexible inflation targeting, and inflation-targeting reaction functions with the Taylor rule. The optimal monetary policy response to various shocks is examined. Flexible CPI-inflation targeting is found to be successful in limiting the variability of CPI inflation, the output gap, and the real exchange rate. Counterintuitively, negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap, and induce similar monetary policy responses. The model provides limited support for a monetary conditions index (MCI) that combines the real exchange rate with a long real interest rate and expected future values, rather than current values. The MCI is not directly observable or verifiable to external observers.