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Taylor rules in the open economy

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  • Leith, Campbell
  • Wren-Lewis, Simon

Abstract

Taylor rules, which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. Their determinacy properties have also been analysed in the context of closed and, to a more limited degree, in small open economy models. In this paper, we extend the analysis of the determinacy properties of Taylor rules to the case of a benchmark two-country model. When the rules are specified in terms of output-price inflation we confirm and extend the conventional results from the closed economy literature--satisfying the Taylor principle is the key to ensuring determinacy, although the presence of backward-looking price-setting can affect the determinacy properties of the two-country model. However, the conventional results do not hold when we replace output-price inflation with consumer price inflation in the specification of the rule. In this case, Taylor rules which satisfy the Taylor principle will be indeterminate, unless there is an unusually large home bias in consumption. Similar indeterminacy problems arise when one country targets CPI inflation and the other output-price inflation. In this case we show that, even if determinacy is achieved, large spillovers may occur between countries.

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  • Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
  • Handle: RePEc:eee:eecrev:v:53:y:2009:i:8:p:971-995
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    Cited by:

    1. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Oxford Economic Papers, Oxford University Press, vol. 63(4), pages 673-699, December.
    2. Leith, Campbell & Wren-Lewis, Simon, 2008. "Interactions between monetary and fiscal policy under flexible exchange rates," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2854-2882, September.
    3. repec:zbw:bofitp:2018_006 is not listed on IDEAS
    4. Airaudo, Marco & Zanna, Luis-Felipe, 2012. "Interest rate rules, endogenous cycles, and chaotic dynamics in open economies," Journal of Economic Dynamics and Control, Elsevier, vol. 36(10), pages 1566-1584.
    5. Stephen McKnight & Alexander Mihailov, 2015. "Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies?," Economica, London School of Economics and Political Science, vol. 82(328), pages 938-975, October.
    6. Zhang, Chengsi & Dang, Chao, 2018. "Is Chinese monetary policy forward-looking?," BOFIT Discussion Papers 6/2018, Bank of Finland, Institute for Economies in Transition.
    7. Teresa Sousa, 2011. "International macroeconomic interdependence and imports of oil in a small open economy," Portuguese Economic Journal, Springer;Instituto Superior de Economia e Gestao, vol. 10(1), pages 35-60, April.
    8. Luis-Felipe Zanna & Mr. Marco Airaudo, 2012. "Interest Rate Rules, Endogenous Cycles, and Chaotic Dynamics in Open Economies," IMF Working Papers 2012/121, International Monetary Fund.
    9. Wolfram Berger, 2010. "International Policy Coordination and Simple Monetary Policy Rules," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 146(II), pages 451-479, June.
    10. Fujisaki, Seiya, 2012. "Interest Rate Control Rules and Macroeconomic Stability in a Heterogeneous Two-Country Model," MPRA Paper 37017, University Library of Munich, Germany.
    11. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages 208-231, June.
    12. Ludger Linnemann & Andreas Schabert, 2006. "Monetary Policy and the Taylor Principle in Open Economies," International Finance, Wiley Blackwell, vol. 9(3), pages 343-367, December.
    13. Gießler, Stefan, 2020. "The evolution of monetary policy in Latin American economies: Responsiveness to inflation under different degrees of credibility," IWH Discussion Papers 9/2020, Halle Institute for Economic Research (IWH).

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    More about this item

    Keywords

    Taylor rules Inflation targeting Interest rate rules;

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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