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Optimal Monetary Policy In An Open Economy


  • Raf Wouters

    (European Central Bank)

  • Frank Smets

    (European Central Bank)


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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    References listed on IDEAS

    1. Brayton, Flint & Levin, Andrew & Lyon, Ralph & Williams, John C., 1997. "The evolution of macro models at the Federal Reserve Board," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 43-81, December.
    2. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
    3. Robert Anderton & Ray Barrell, 1995. "The ERM and structural change in European labour markets: A study of 10 countries," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 131(1), pages 47-66, March.
    4. repec:sae:niesru:v:156:y::i:1:p:72-79 is not listed on IDEAS
    5. Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "The Perils of Taylor Rules," Journal of Economic Theory, Elsevier, vol. 96(1-2), pages 40-69, January.
    6. Glenn Rudebusch & Lars E.O. Svensson, 1999. "Policy Rules for Inflation Targeting," NBER Chapters,in: Monetary Policy Rules, pages 203-262 National Bureau of Economic Research, Inc.
    7. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
    8. Clements,Michael & Hendry,David, 1998. "Forecasting Economic Time Series," Cambridge Books, Cambridge University Press, number 9780521634809, March.
    9. repec:sae:niesru:v:164:y::i:1:p:90-99 is not listed on IDEAS
    10. Barrell, Ray & Sefton, James, 1997. "Fiscal Policy and the Masstricht Solvency Criteria," The Manchester School of Economic & Social Studies, University of Manchester, vol. 65(3), pages 259-279, June.
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    Cited by:

    1. 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.
    2. Corsetti, Giancarlo & Pesenti, Paolo, 2005. "International dimensions of optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 281-305, March.
    3. 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.
    4. 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.
    5. Neiss, Katharine S. & Nelson, Edward, 2003. "The Real-Interest-Rate Gap As An Inflation Indicator," Macroeconomic Dynamics, Cambridge University Press, vol. 7(02), pages 239-262, April.
    6. 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.
    7. 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.
    8. Sutherland, Alan, 2001. "Inflation Targeting in a Small Open Economy," CEPR Discussion Papers 2726, C.E.P.R. Discussion Papers.

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