When do open economy rules perform badly? Identifying fault tolerant monetary policy

When a central bank operates with multiple, non-nested models of the economy, generally no single policy rule will be optimal across within alternate models. In this context, Levin and Williams (2003) introduce the notion of fault tolerance of policy rules, that is, the performance of policy rules when a single element of the rule is misspecified or malfunctioning. Fault tolerance explores straight-forward calculations that illustrate how minimax and Bayesian design rules slant standard rules to take account of potential errors. Mostly, theoretical models developed from optimizing behaviour of agents, predict small and trivial gains to responding to the exchange rate (see Clarida (2001) et al. for example). However, Dennis (2003) argues that models that replicate key characteristics of the data for open economy targeters suggest policymakers should respond to the real exchange rate. This paper explores the fault tolerance of three open economy models that motivate the dynamics of the open economy from alternative theoretical assumptions. The first model is a hybrid variant of the McCallum and Nelson model (1999) and Batini and Nelson model (2001), the second model is the entirely backward-looking Ball (1999) model and the third model is a simplified version of the Galí and Monacelli (2004) model, where the exchange rate is determined by PPP. Results for the first two models show that the appropriate inflation, output gap and exchange rate response are relatively fault tolerant across models. However, the response to the lag of the interest rate is particularly fault intolerant, ceteris paribus, the hybrid model is explosive with the Ball response coefficient and the macroeconomic volatility of the hybrid model increases by 82% under the Ball interest-rate smoothing coefficient. Thus it appears that the response to the real exchange rate is relatively benign and it is the degree of interest rate smoothing that is crucial for monetary policy.