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Policy Rules for Open Economies

Author

Listed:
  • Laurence Ball

    (Johns Hopkins University)

Abstract

This paper examines the choice of a monetary policy rule in a simple macroeconomic model. In a closed economy, the optimal policy is a ‘Taylor rule’ in which the interest rate depends on output and inflation. In an open economy, the optimal rule changes in two ways. First, the policy instrument is a ‘Monetary Conditions Index’ – a weighted average of the interest rate and the exchange rate. Second, on the right side of the rule, inflation is replaced by ‘long-run inflation’, a variable that filters out the transitory effects of exchange-rate movements. The model also implies that pure inflation targeting is dangerous in an open economy, because it creates large fluctuations in exchange rates and output. Targeting long-run inflation avoids this problem and produces a close approximation to the optimal instrument rule.

Suggested Citation

  • Laurence Ball, 1998. "Policy Rules for Open Economies," RBA Research Discussion Papers rdp9806, Reserve Bank of Australia.
  • Handle: RePEc:rba:rbardp:rdp9806
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    File URL: https://www.rba.gov.au/publications/rdp/1998/pdf/rdp9806.pdf
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    References listed on IDEAS

    as
    1. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    2. Gerlach, Stefan & Smets, Frank, 2000. "MCIs and monetary policy," European Economic Review, Elsevier, vol. 44(9), pages 1677-1700, October.
    3. Laurence Ball, 1999. "Efficient Rules for Monetary Policy," International Finance, Wiley Blackwell, vol. 2(1), pages 63-83, April.
    4. Mankiw, N. Gregory (ed.), 1997. "Monetary Policy," National Bureau of Economic Research Books, University of Chicago Press, number 9780226503097.
    5. Ball, Laurence, 1995. "Time-consistent policy and persistent changes in inflation," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 329-350, November.
    6. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February.
    7. David Gruen & Geoffrey Shuetrim, 1994. "Internationalisation and the Macroeconomy," RBA Annual Conference Volume (Discontinued), in: Philip Lowe & Jacqueline Dwyer (ed.),International Intergration of the Australian Economy, Reserve Bank of Australia.
    8. Hendry, David F., 1995. "Dynamic Econometrics," OUP Catalogue, Oxford University Press, number 9780198283164.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    monetary policy rules; inflation targeting;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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