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Uncertain potential output: implications for monetary policy in small open economy

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  • Traficante, Guido

Abstract

A huge literature analyzes the performance of simple rules in closed-economy models when the policy-maker observes only a noisy measure of the state of the economy. This paper extends the analysis to a small-open economy new keynesian model. Passing from a closed-economy model to an open-economy one, there is another simple policy rule available to the central bank, namely the exchange rate peg. Hence, evaluating the performance of simple rules allows us to assess if the choice of the exchange rate regime depends on the uncertainty about the true state of the economy. Evaluating the conduct of monetary policy in terms of a Taylor rule, this paper shows that not reacting to the exchange rate yields better outcomes in terms of a standard loss function and quantifies for which parameter configuration in terms of the reaction to the exchange rate and the domestic inflation rate, the fixed exchange rate regime is to be preferred. The analysis is done both with complete and with incomplete information.

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Bibliographic Info

Paper provided by CEPREMAP in its series Dynare Working Papers with number 22.

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Length: 15 pages
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:cpm:dynare:022

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Keywords: small open economy; exchange rate regime; monetary policy rules; uncertainty;

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References

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  1. Michael Woodford & Pierpaolo Benigno, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," 2004 Meeting Papers, Society for Economic Dynamics 481, Society for Economic Dynamics.
  2. Ehrmann, Michael & Smets, Frank, 2001. "Uncertain potential output: implications for monetary policy," Working Paper Series, European Central Bank 0059, European Central Bank.
  3. Leitemo, Kai & Soderstrom, Ulf, 2005. "Simple monetary policy rules and exchange rate uncertainty," Journal of International Money and Finance, Elsevier, Elsevier, vol. 24(3), pages 481-507, April.
  4. Glenn D. Rudebusch, 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series, Federal Reserve Bank of San Francisco 2000-03, Federal Reserve Bank of San Francisco.
  5. Levin, Andrew & Wieland, Volker & Williams, John C., 2003. "The performance of forecast-based monetary policy rules under model uncertainty," CFS Working Paper Series, Center for Financial Studies (CFS) 2003/06, Center for Financial Studies (CFS).
  6. Andrew T. Levin & John C. Williams, 2003. "Robust monetary policy with competing reference models," Working Paper Series, Federal Reserve Bank of San Francisco 2003-10, Federal Reserve Bank of San Francisco.
  7. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator variables for optimal policy," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco.
  8. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  9. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," NBER Working Papers 9566, National Bureau of Economic Research, Inc.
  10. Berger, Wolfram, 2006. "The choice between fixed and flexible exchange rates: Which is best for a small open economy?," Journal of Policy Modeling, Elsevier, Elsevier, vol. 28(4), pages 371-385, May.
  11. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers, C.V. Starr Center for Applied Economics, New York University 99-13, C.V. Starr Center for Applied Economics, New York University.
  12. Mirco Soffritti & Francesco Zanetti, 2008. "The advantage of tying one's hands: revisited," International Journal of Finance & Economics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 13(2), pages 135-149.
  13. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, American Economic Association, vol. 91(4), pages 964-985, September.
  14. Gianluca Benigno & Pierpaolo Benigno & Fabio Ghironi, 2000. "Interest Rate Rules for Fixed Exchange Rate Regimes," Boston College Working Papers in Economics, Boston College Department of Economics 468, Boston College Department of Economics, revised 13 Oct 2003.
  15. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  16. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, Elsevier, vol. 77(1), pages 11-22, February.
  17. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 248-252, May.
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