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Efficient CPI-Based Taylor Rules in Small Open Economies

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  • Rodrigo Caputo
  • Luis Oscar Herrera

Abstract

In a standard New-Keynesian model for a small open economy, we derive the efficient CPI inflationbased Taylor rule. We conclude that the natural rate of interest, based on CPI inflation, must be directly linked to the foreign interest rate, as well as to domestic productivity shocks. In this way this rule ensures that the real ex-ante CPI interest rate moves in the face of domestic and foreign shocks so as to induce efficient movements in consumption. The empirical evidence, on the other hand, shows that inflation-targeting central banks respond to movements in the foreign interest rate (Fed funds rate), besides reacting to expected CPI inflation and to the domestic output gap.

Suggested Citation

  • Rodrigo Caputo & Luis Oscar Herrera, 2013. "Efficient CPI-Based Taylor Rules in Small Open Economies," Working Papers Central Bank of Chile 694, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:694
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    References listed on IDEAS

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    Cited by:

    1. Gustavo Adler & Ruy Lama & Juan Pablo Medina Guzman, 2016. "Foreign Exchange Intervention under Policy Uncertainty," IMF Working Papers 16/67, International Monetary Fund.
    2. Pablo García, 2016. "Latin America´s Challenges in an Era of Secular Stagnation," Economic Policy Papers Central Bank of Chile 60, Central Bank of Chile.

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