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Policy Rules for Open Economies

In: Monetary Policy Rules

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  • Laurence M. Ball

Abstract

This 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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Suggested Citation

  • Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberch:7415
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    References listed on IDEAS

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    1. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    2. Gerlach, Stefan & Smets, Frank, 2000. "MCIs and monetary policy," European Economic Review, Elsevier, vol. 44(9), pages 1677-1700, October.
    3. Laurence Ball, 1999. "Efficient Rules for Monetary Policy," International Finance, Wiley Blackwell, vol. 2(1), pages 63-83, April.
    4. Mankiw, N. Gregory (ed.), 1997. "Monetary Policy," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226503097, March.
    5. Ball, Laurence, 1995. "Time-consistent policy and persistent changes in inflation," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 329-350, November.
    6. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February.
    7. David Gruen & Geoffrey Shuetrim, 1994. "Internationalisation and the Macroeconomy," RBA Annual Conference Volume (Discontinued), in: Philip Lowe & Jacqueline Dwyer (ed.),International Intergration of the Australian Economy, Reserve Bank of Australia.
    8. Hendry, David F., 1995. "Dynamic Econometrics," OUP Catalogue, Oxford University Press, number 9780198283164.
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    More about this item

    JEL classification:

    • 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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