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Monetary policy rules for an open economy

  • Batini, Nicoletta
  • Harrison, Richard
  • Millard, Stephen P.

The most popular simple rules, due to Taylor (1993) and McCallum (1995), are both meant to inform monetary policy in economies that are closed. On the other hand, their main open economy alternative, the Monetary Conditions Index (MCI) rule of Ball (1999) is flawed for a number or reasons, not least because it fails to adequately allow for different types of exchange rate shocks when setting policy. In this paper we derive simple monetary policy rules that are suitable for small open economies in general, and for the UK in particular. We do so by comparing the performance of a battery of complex and simple rules, including the familiar Taylor and McCallum rule and the MCI. The comparison entails stochastically simulating a two-sector open-economy stochastic dynamic general equilibrium model calibrated on UK data. The model displays persistence in the process of domestically generated inflation that arises by assuming 'generalised habit formation' in the preferences for both consumption and leisure.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 27 (2003)
Issue (Month): 11-12 (September)
Pages: 2059-2094

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Handle: RePEc:eee:dyncon:v:27:y:2003:i:11-12:p:2059-2094
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