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Openness and Equilibrium Determinacy under Interest Rate Rules

  • Fiorella De Fiore
  • Zheng Liu

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.

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Paper provided by Department of Economics, Emory University (Atlanta) in its series Emory Economics with number 0310.

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Date of creation: May 2003
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Handle: RePEc:emo:wp2003:0310
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  1. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies.
  2. McCallum, Bennett T & Nelson, Edward, 2000. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," Oxford Review of Economic Policy, Oxford University Press, vol. 16(4), pages 74-91, Winter.
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  18. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
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