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Efficient CPI-Based Taylor Rules in Small Open Economies

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  • Rodrigo Caputo
  • Luis Oscar Herrera
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    Abstract

    In a standard New-Keynesian model for a small open economy, we derive the efficient CPI inflationbased Taylor rule. We conclude that the natural rate of interest, based on CPI inflation, must be directly linked to the foreign interest rate, as well as to domestic productivity shocks. In this way this rule ensures that the real ex-ante CPI interest rate moves in the face of domestic and foreign shocks so as to induce efficient movements in consumption. The empirical evidence, on the other hand, shows that inflation-targeting central banks respond to movements in the foreign interest rate (Fed funds rate), besides reacting to expected CPI inflation and to the domestic output gap.

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    Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 694.

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    Date of creation: Jul 2013
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    Handle: RePEc:chb:bcchwp:694

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    4. Svensson, L-E-O, 1997. "Inflation Targeting : Some Extensions," Papers 625, Stockholm - International Economic Studies.
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