Taylor Rules in the Open Economy

Taylor rules which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. A key question that arises when analysing the conduct of such policy rules in the open economy case is whether the relevant measure of inflation is the growth in output prices or consumer prices. In this paper, we show that embedding a rule specified in terms of output price inflation into a benchmark two-country model confirms the existing result that local stability requires that the response of nominal interest rates to excess inflation should be such that real interest rates rise (the Taylor Principle), but this requirement may be partially offset by raising the interest rate response to increases in the output gap. However, all the conventional results do not hold when we replace output price inflation with consumer price inflation. In this case, Taylor rules which satisfy the Taylor principle will not support a unique rational expectations path for prices and other macroeconomic variables in response to specific shocks. Our results suggest that adoption of consumer price based Taylor rules might be chronically destabilising.