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Optimal Monetary Policy In An Open Economy

Author

Listed:
  • Raf Wouters

    (European Central Bank)

  • Frank Smets

    (European Central Bank)

Abstract

This paper analyses optimal monetary policy in a linearised open-economy dynamic general equilibrium model with sticky prices. The model extends a version of the new-Keynesian closed economy model discussed in Rotemberg and Woodford (1997), Goodfriend and King (1997) and Clarida, Gali and Gertler (1999) to an open economy context. Through the interest rate parity condition, changes in the interest rate (the central bank's instrument) have an impact on the exchange rate and the terms of trade, which in turn affects import prices and net exports. We calibrate the model to the euro area economy following the approach by Rotemberg and Woodford (1997). This approach consists of choosing some of the structural parameters of the model to match the empirical transmission mechanism of monetary policy as captured by a VAR. For this purpose we estimate a VAR-model in euro-area wide real GDP, inflation, the real exchange rate and a short-term nominal interest rate. The structural shocks (other than monetary policy shocks) are calculated so as to match the cross-correlations of the four variables implied by the VAR. Using the empirical version of the open-economy DGE model with sticky domestic prices, we then analyse optimal monetary policy. Again, we follow Rotemberg and Woodford (1997) in deriving a welfare criterion based on maximising the welfare of the representative agent in the economy. In contrast to the closed economy analysis of Goodfriend and King (1997) and Aoki (1999), the existence of an exchange rate channel and terms-of-trade effects does create a trade-off between stabilising the output gap and domestic inflation. We examine the empirical relevance of this trade-off and compare the outcome under commitment to the optimal policy with the outcome when various simple instrument and targeting rules that have been explored in the literature are used.

Suggested Citation

  • Raf Wouters & Frank Smets, 2000. "Optimal Monetary Policy In An Open Economy," Computing in Economics and Finance 2000 186, Society for Computational Economics.
  • Handle: RePEc:sce:scecf0:186
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    Citations

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    Cited by:

    1. Kollmann, Robert, 2003. "Monetary Policy Rules in an Interdependent World," CEPR Discussion Papers 4012, C.E.P.R. Discussion Papers.
    2. Batini, Nicoletta & Harrison, Richard & Millard, Stephen P., 2003. "Monetary policy rules for an open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 27(11-12), pages 2059-2094, September.
    3. Corsetti, Giancarlo & Pesenti, Paolo, 2005. "International dimensions of optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 281-305, March.
    4. 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.
    5. Smets, Frank & Wouters, Raf, 2002. "Openness, imperfect exchange rate pass-through and monetary policy," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 947-981, July.
    6. Neiss, Katharine S. & Nelson, Edward, 2003. "The Real-Interest-Rate Gap As An Inflation Indicator," Macroeconomic Dynamics, Cambridge University Press, vol. 7(2), pages 239-262, April.
    7. Kollmann, Robert, 2002. "Monetary policy rules in the open economy: effects on welfare and business cycles," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 989-1015, July.
    8. Sutherland, Alan, 2001. "Inflation Targeting in a Small Open Economy," CEPR Discussion Papers 2726, C.E.P.R. Discussion Papers.
    9. Kollmann, Robert, 2002. "Monetary Policy Rules in a Two-Country World," MPRA Paper 70347, University Library of Munich, Germany.
    10. Deming Luo & Stephen Ferris, 2008. "Optimal Simple Monetary Policy Rules in a Small Open Economy with Exchange Rate Imperfections," Carleton Economic Papers 08-03, Carleton University, Department of Economics.
    11. Fabio Ghironi, 2000. "Alternative Monetary Rules for a Small Open Economy: The Case of Canada," Boston College Working Papers in Economics 466, Boston College Department of Economics, revised 30 Oct 2000.

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