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Caution or Activism? Monetary Policy Strategies in an Open Economy

  • Ellison, Martin
  • Sarno, Lucio
  • Vilmunen, Jouko

We examine optimal policy in a two-country model with uncertainty and learning, where monetary policy actions affect the real economy through the real exchange rate channel. Our results show that whether policy should be cautious or activist depends on the size of one country relative to another. If one country is small relative to the other then activism is optimal. In contrast, if the two countries are equal sized then caution prevails. Caution is induced in the latter case because of the interaction between the home and foreign central banks. In a two-country symmetric equilibrium, learning is shown to be detrimental to welfare, implying that optimal policy is cautious.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4766.

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Date of creation: Nov 2004
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Handle: RePEc:cpr:ceprdp:4766
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  1. Svensson, Lars E O, 1996. "Price-level Targeting versus Inflation Targeting: A Free Lunch?," CEPR Discussion Papers 1510, C.E.P.R. Discussion Papers.
  2. Bertocchi, Graziella & Spagat, Michael, 1993. "Learning, experimentation, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 169-183, August.
  3. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, June.
  4. Frankel, Jeffrey A & Rockett, Katharine E, 1988. "International Macroeconomic Policy Coordination When Policymakers Do Not Agree on the True Model," American Economic Review, American Economic Association, vol. 78(3), pages 318-40, June.
  5. Wieland, Volker, 2000. "Monetary policy, parameter uncertainty and optimal learning," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 199-228, August.
  6. Kiefer, Nicholas M & Nyarko, Yaw, 1989. "Optimal Control of an Unknown Linear Process with Learning," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(3), pages 571-86, August.
  7. Basar, Tamer & Salmon, Mark, 1987. "Credibility and the Value of Information Transmission in a Model of Monetary Policy and Inflation," The Warwick Economics Research Paper Series (TWERPS) 289, University of Warwick, Department of Economics.
  8. Wieland, Volker, 2000. "Learning by doing and the value of optimal experimentation," Journal of Economic Dynamics and Control, Elsevier, vol. 24(4), pages 501-534, April.
  9. Ghosh, Atish R & Masson, Paul R, 1991. "Model Uncertainty, Learning, and the Gains from Coordination," American Economic Review, American Economic Association, vol. 81(3), pages 465-79, June.
  10. Ellison, Martin & Vilmunen, Jouko, 2005. "A simple approach to identifying the incentives for policy experimentation," Economics Letters, Elsevier, vol. 86(2), pages 167-172, February.
  11. Balvers, Ronald J & Cosimano, Thomas F, 1994. "Inflation Variability and Gradualist Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 721-38, October.
  12. Carl E. Walsh, 2003. "Monetary Theory and Policy, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262232316, June.
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