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Monetary Policy and the Taylor Principle in Open Economies

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  • Ludger Linnemann
  • Andreas Schabert

Abstract

Nowadays, central banks mostly conduct monetary policy by setting nominal interest rates. A widely held view is that central banks can stabilize inflation if they follow the Taylor principle, which requires raising the nominal interest rate more than one-for-one in response to higher inflation. Is this also correct in an economy open to international trade? Exchange rate changes triggered by interest rate policy might interfere with inflation stabilization if they alter import prices. The paper shows that this destabilizing effect can prevail if (a) the central bank uses consumer (rather than producer) prices as its inflation indicator or directly reacts to currency depreciation, and (b) if it bases interest rate decisions on expected future inflation. Thus, if the central bank looks at current inflation rates and ignores exchange rate changes, Taylor-style interest rate setting policies are advisable in open economies as well. Copyright 2006 Blackwell Publishing Ltd.

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Bibliographic Info

Article provided by Wiley Blackwell in its journal International Finance.

Volume (Year): 9 (2006)
Issue (Month): 3 (December)
Pages: 343-367

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Handle: RePEc:bla:intfin:v:9:y:2006:i:3:p:343-367

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Cited by:
  1. Stephen McKnight, 2007. "Investment and Interest Rate Policy in the Open Economy," Economic Analysis Research Group Working Papers earg-wp2007-11, Henley Business School, Reading University.
  2. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
  3. Borek Vasicek, 2009. "Monetary policy rules and inflation process in open emerging economies: evidence for 12 new EU members," William Davidson Institute Working Papers Series wp968, William Davidson Institute at the University of Michigan.
  4. Stephen McKnight & Alexander Mihailov, 2012. "Do real balance effects invalidate the Taylor principle in closed and open economies?," Serie documentos de trabajo del Centro de Estudios Económicos 2012-10, El Colegio de México, Centro de Estudios Económicos.

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