Policy Rules and External Shocks
This essay discusses rules for monetary policy in open economies. If policymakers seek to stabilize output and inflation, optimal rules in open economies differ considerably from optimal rules in closed economies. In open economies, stability is best achieved by targeting long-run inflation' a measure of inflation adjusted to remove transitory effects of exchange-rate movements. Stability is also enhanced by adding an exchange-rate term to "Taylor rules" for setting interest rates. Finally, central banks must choose whether their policy instrument is an interest rate or a "monetary conditions index": an average of the interest rate and the exchange rate. The nature of shocks to the exchange rate determines which of these choices keeps output and inflation more stable.
|Date of creation:||Sep 2000|
|Date of revision:|
|Publication status:||published as Loayza, Norman and Klaus Schmidt-Hebbel. Monetary policy: Rules and transmission mechanisms, Series on Central Banking, Analysis, and Economic Policies, vol. 4. Santiago: Central Bank of Chile, 2002.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
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- Laurence Ball, 1998.
"Policy Rules for Open Economies,"
NBER Working Papers
6760, National Bureau of Economic Research, Inc.
- Philip Lowe & Luci Ellis, 1997. "The Smoothing of Official Interest Rates," RBA Annual Conference Volume, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia.
- William Poole, 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," The Quarterly Journal of Economics, Oxford University Press, vol. 84(2), pages 197-216.
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