Policy Rules for Open Economies
AbstractThis paper examines the choice of a monetary policy rule in a simple macroeconomic model. In a closed economy, the optimal policy is a ‘Taylor rule’ in which the interest rate depends on output and inflation. In an open economy, the optimal rule changes in two ways. First, the policy instrument is a ‘Monetary Conditions Index’ – a weighted average of the interest rate and the exchange rate. Second, on the right side of the rule, inflation is replaced by ‘long-run inflation’, a variable that filters out the transitory effects of exchange-rate movements. The model also implies that pure inflation targeting is dangerous in an open economy, because it creates large fluctuations in exchange rates and output. Targeting long-run inflation avoids this problem and produces a close approximation to the optimal instrument rule.
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Bibliographic InfoPaper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9806.
Date of creation: Jul 1998
Date of revision:
Other versions of this item:
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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