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On discretion versus commitment and the role of the direct exchange rate channel in a forward-looking open economy model

  • Alfred Guender

This paper compares optimal monetary policy under discretion and commitment in an economy where the direct exchange rate channel is operative. The stabilization bias under discretion is shown to be weaker in an open economy relative to a closed economy. In an open economy, a 'less conservative central banker', one that attaches a smaller weight to the variance of inflation in the loss function, can be appointed to replicate the behaviour of real output that eventuates under commitment. Evaluating the social loss function under discretion and commitment, we find that the existence of a direct exchange rate channel in the Phillips Curve mitigates the pronounced differences between the two strategies in case of high persistence in the stochastic shocks.

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Article provided by Taylor & Francis Journals in its journal International Economic Journal.

Volume (Year): 19 (2005)
Issue (Month): 3 ()
Pages: 355-377

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Handle: RePEc:taf:intecj:v:19:y:2005:i:3:p:355-377
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