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Determinacy and Learnability of Monetary Policy Rules in Small Open Economies

  • Luis Gonzalo Llosa
  • Vicente Tuesta

This paper evaluates under which conditions different Taylor-type rules lead to determinacy and expectational stability (E-stability) of rational expectations equilibrium in a simple New Keynesian small open economy model, developed by Gali and Monacelli (2005). In particular, we extend the Bullard and Mitra (2002) results of determinacy and E-stability in a closed economy to this small open economy framework. Our results highlight an important link between the Taylor principle and both determinacy and learnability of equilibrium in small open economies. More importantly, the degree of openness coupled with the nature of the policy rule adopted by the monetary authorities might change this link in important ways. A key finding is that, contrary to Bullard and Mitra, expectations-based rules that involve the CPI and/or the nominal exchange rate limit the region of E-stability and the Taylor Principle does not guarantee E-stability. We also show that some forms of managed exchange rate rules can help to alleviate problems of both indeterminacy and expectational instability, yet these rules might not be desirable since they promote greater volatility in the economy.

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Paper provided by Inter-American Development Bank, Research Department in its series Research Department Publications with number 4479.

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Date of creation: Dec 2006
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Handle: RePEc:idb:wpaper:4479
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  2. James Bullard & Eric Schaling, 2005. "Monetary Policy, Determinacy, and Learnability in the Open Economy," Working Papers 11, Economic Research Southern Africa.
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  16. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
  17. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2004. "Indeterminacy with Inflation-Forecast-Based Rules in a Two-Bloc Model," School of Economics Discussion Papers 0204, School of Economics, University of Surrey.
  18. 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.
  19. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  20. James B. Bullard & Aarti Singh, 2007. "Worldwide macroeconomic stability and monetary policy rules," Working Papers 2006-040, Federal Reserve Bank of St. Louis.
  21. Evans, George W. & Honkapohja, Seppo, 1999. "Learning dynamics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 7, pages 449-542 Elsevier.
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