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Uncertain potential output: implications for monetary policy in small open economy

  • Traficante, Guido

A huge literature analyzes the performance of simple rules in closed-economy models when the policy-maker observes only a noisy measure of the state of the economy. This paper extends the analysis to a small-open economy new keynesian model. Passing from a closed-economy model to an open-economy one, there is another simple policy rule available to the central bank, namely the exchange rate peg. Hence, evaluating the performance of simple rules allows us to assess if the choice of the exchange rate regime depends on the uncertainty about the true state of the economy. Evaluating the conduct of monetary policy in terms of a Taylor rule, this paper shows that not reacting to the exchange rate yields better outcomes in terms of a standard loss function and quantifies for which parameter configuration in terms of the reaction to the exchange rate and the domestic inflation rate, the fixed exchange rate regime is to be preferred. The analysis is done both with complete and with incomplete information.

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Paper provided by CEPREMAP in its series Dynare Working Papers with number 22.

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Length: 15 pages
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:cpm:dynare:022
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  1. Svensson, Lars E. O. & Woodford, Michael, 2000. "Indicator variables for optimal policy," Working Paper Series 0012, European Central Bank.
  2. John C. Williams & Andrew T. Levin, 2003. "Robust Monetary Policy with Competing Reference Models," Computing in Economics and Finance 2003 291, Society for Computational Economics.
  3. Gerali, Andrea & Lippi, Francesco, 2003. "Optimal Control and Filtering in Linear Forward-looking Economies: A Toolkit," CEPR Discussion Papers 3706, C.E.P.R. Discussion Papers.
  4. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  5. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics 19950, London School of Economics and Political Science, LSE Library.
  6. Leitemo, Kai & Söderström, Ulf, 2001. "Simple Monetary Policy Rules and Exchange Rate Uncertainty," Working Paper Series 122, Sveriges Riksbank (Central Bank of Sweden).
  7. Andrew Levin & John C. Williams, 2000. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," Econometric Society World Congress 2000 Contributed Papers 1781, Econometric Society.
  8. Pierpaolo Benigno & Michael Woodford, 2004. "Inflation Stabilization and Welfare: The Case of a Distorted Steady State," NBER Working Papers 10838, National Bureau of Economic Research, Inc.
  9. Benigno, Gianluca & Benigno, Pierpaolo & Ghironi, Fabio, 2007. "Interest rate rules for fixed exchange rate regimes," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2196-2211, July.
  10. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  11. Ehrmann, M. & Smets, F., 2001. "Uncertain Potential Output: Implications for Monetary Policy," Papers 59, Quebec a Montreal - Recherche en gestion.
  12. Berger, Wolfram, 2006. "The choice between fixed and flexible exchange rates: Which is best for a small open economy?," Journal of Policy Modeling, Elsevier, vol. 28(4), pages 371-385, May.
  13. Mirco Soffritti & Francesco Zanetti, 2008. "The advantage of tying one's hands: revisited," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 13(2), pages 135-149.
  14. Rudebusch, Glenn D., 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series 0014, European Central Bank.
  15. Clarida, Richard & Galí, Jordi & Gertler, Mark, 2002. "A Simple Framework for International Monetary Policy Analysis," CEPR Discussion Papers 3355, C.E.P.R. Discussion Papers.
  16. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," NBER Working Papers 9566, National Bureau of Economic Research, Inc.
  17. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
  18. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
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