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Openness and equilibrium determinacy under interest rate rules

  • De Fiore, Fiorella
  • Liu, Zheng

This paper shows that the conditions under which inflation-targeting interest rate rules lead to equilibrium uniqueness in a small open economy in general differ from those in a closed economy. As the monetary authority adjusts nominal interest rates in response to inflation, the real interest rate changes. The overall effect of this change on aggregate demand has important implications for equilibrium determinacy. In an open economy, an increase in the real interest rate is transmitted to aggregate demand through an intertemporal substitution effect, as in a closed economy, but also through a terms of trade effect that is absent in the closed economy. These effects move aggregate demand in opposite directions. We find that, in a broad class of models, the conditions for local equilibrium uniqueness depend crucially on the degree of openness to international trade. Openness matters not only quantitatively, but also qualitatively. JEL Classification: E52, E58, F41

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Paper provided by European Central Bank in its series Working Paper Series with number 0173.

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Date of creation: Sep 2002
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Handle: RePEc:ecb:ecbwps:20020173
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  1. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
  2. McCallum, Bennett T & Nelson, Edward, 2001. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," CEPR Discussion Papers 2756, C.E.P.R. Discussion Papers.
  3. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
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  14. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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  17. Isabel Correia & Pedro Teles, 1999. "The Optimal Inflation Tax," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 2(2), pages 325-346, April.
  18. William Kerr & Robert G. King, 1996. "Limits on interest rate rules in the IS model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 47-75.
  19. Charles T. Carlstrom & Timothy S. Fuerst, 2001. "Taylor rules in a model that satisfies the natural rate hypothesis," Working Paper 0116, Federal Reserve Bank of Cleveland.
  20. Lawrence J. Christiano & Massimo Rostagno, 2001. "Money Growth Monitoring and the Taylor Rule," NBER Working Papers 8539, National Bureau of Economic Research, Inc.
  21. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
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