Research on monetary policy rules takes as given that central banks should have a goal or target for the rate of inflation. This inflation targeting may be explicit as in New Zealand, the U.K., and Euroland or implicit as in the US. Most economic researchers also assume that the central bank should implement its monetary policy through the guidance of a policy rule or a portfolio of such rules. Such a rule describes how the instruments of the central bank are adjusted in response to developments in the economy. A well-known example of such an instrument rule is the so-called Taylor rule, according to which the short-term interest rate should be adjusted to movements in income and inflation. Research on the Taylor rule has been very active and has focused on two aspects. Firstly, in a welfare analysis the efficiency of different types of Taylor rules has been investigated on a variety of models. Secondly, the Taylor rule has been used as a simple framework in the spirit of Friedman and Schwartz to describe the policies central banks have pursued in the past. So far, the theoretical literature has mainly assumed a closed economy framework. This paper wants to contribute to the analysis of Taylor rules in an open economy. Based on Ball (1999) it analyses in a first step how the optimal monetary policy changes in an open economy. In this case, the Taylor rule has to be modified, for monetary policy does not only affect the economy via the interest rate channel but also via the exchange rate. Secondly, the paper investigates in a Taylor rule framework which monetary policies central banks have actually pursued. By comparing these results of the positive analysis with the welfare analysis we then try to evaluate the actual policies and the suitability of the Taylor rule as a monetary instrument rule. Section B. introduces a simple dynamic model of a small open economy, and section C. derives the optimal instrument rule in a calibrated version of the model. Section D. presents results from estimating Taylor rules and relates the estimations to the results from the calibrated model. Section E. concludes and discusses some policy considerations.
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