Endogenous Fluctuations in Open Economies: the Perils of Taylor Rules Revisited

Can active Taylor rules (i.e. monetary rules where the nominal interest rate responds more than proportionally to inflation) deliver global equilibrium uniqueness in small open economies? By studying the local and global dynamics of a standard small open economy we point out the misleading results and policy advices that one would derive from a standard local analysis. We show that rules that guarantee a local unique equilibrium may actually lead the economy into liquidty traps, cycles and chaos. More importantly we find that there is an interesting interaction between the relative risk aversion coefficient and the degree of openness that determines the nature of the global dynamics of the aforementioned economy. In particular, given the relative risk aversion coefficient, we show that the more open the economy is, the more likely is that a contemporaneous rule will drive the economy into a liquidity trap. On the other hand, the more closed the economy is, the more likely is that the same rule will lead to cycles and chaotic dynamics around the inflation target. In contrast for forward-looking rules we find that given the relative risk aversion coefficient, it is more likely that these rules will lead the economy into cycles and chaos, the higher the degree of openness of the economy is. Although the perils of Taylor rules are evident, the monetary authority can still play a role by at least eliminating cyclical equilibria without giving up its local stability properties. This can be achieved by targeting a high enough inflation level and by being “not too aggressive†with respect to this target, with such relative levels being functions of the “cash dependency†of the economy. Through a simple calibration exercise, we provide a quantitative evaluation of how feasible and relevant our analytically derived results are for the design of monetary policy. In this sense the theoretical results of this paper might provide some warning for small open economies moving to inflation targeting regimes through interest rates feedback rules and Ricardian fiscal rules