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Robust Taylor rules in an open economy with heterogeneous expectations and least squares learning

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Author Info
Bask, Mikael () (Bank of Finland Research)
Selander, Carina (Umeå University)

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Abstract

The aim of this paper is threefold: (i) to investigate if there is a unique rational expectations equilibrium (REE) in the small open economy in Galí and Monacelli (2005) that is augmented with technical trading in the foreign exchange market; (ii) to investigate if the unique REE is adaptively learnable in a recursive least squares sense; and (iii) to investigate if the unique and adaptively learnable REE is desirable in an inflation rate targeting regime in the sense that a low and not too variable CPI inflation rate in equilibrium is achieved. The monetary authority is using a Taylor rule when setting the nominal interest rate, and we investigate numerically the properties of the model developed. A main conclusion is that the monetary authority should increase (decrease) the interest rate when the CPI inflation rate increases (decreases) and when the currency gets stronger (weaker) to have a desirable rule that is robust with respect to the degree of technical trading in the foreign exchange market. Thus, the value of the currency is a better response variable than the output gap in the most desirable parametrizations of the interest rate rule.

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Paper provided by Bank of Finland in its series Research Discussion Papers with number 6/2007.

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Length: 54 pages
Date of creation: 09 May 2007
Date of revision:
Handle: RePEc:hhs:bofrdp:2007_006

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.bof.fi/en/tutkimus
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Related research
Keywords: determinacy; foreign exchange; inflation rate targeting regime; interest rate rule; robust monetary policy; technical trading;

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
F31 - International Economics - - International Finance - - - Foreign Exchange

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jokivuolle, Esa & Kilponen , Juha & Kuusi, Tero, 2007. "GDP at risk in a DSGE model: an application to banking sector stress testing," Research Discussion Papers 26/2007, Bank of Finland. [Downloadable!]
  2. Tervala, Juha, 2007. "The international transmission of monetary policy in a dollar pricing model," Research Discussion Papers 29/2007, Bank of Finland. [Downloadable!]
  3. Bask, Mikael, 2007. "Measuring potential market risk," Research Discussion Papers 20/2007, Bank of Finland. [Downloadable!]
  4. Laakkonen, Helinä, 2007. "Exchange rate volatility, macro announcements and the choice of intraday seasonality filtering method," Research Discussion Papers 23/2007, Bank of Finland. [Downloadable!]
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