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Optimal Flexible Inflation Targeting, Interest-rate Smoothing and the Open Economy

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  • Timothy Kam

    (UWA Business School, The University of Western Australia)

Abstract

Optimal monetary policy design in the context of a small open economy is studied in this paper. The monetary-policy design problem for the small open economy need not be isomorphic to the closed-economy problem. In this paper, the existence of endogenous deviations from the law of one price makes achieving the objectives of monetary policy a task fraught with compromises. The paper shows that, in such an economy, the interest-rate rule under pre-commitment is one that is forward and backward looking in terms of domestic and foreign technology shocks, and is intrinsically inertial. It also shows that the interest-rate rules that arise from discretion take the generic form of Taylor-type rules with CPI inflation as the measure of inflation. It is shown that if the central bank has the incentive to deviate from a commitment policy (a time-inconsistency problem), it may be optimal to delegate policy making to a central banker who has a taste for smoother interest-rate movements - an interest-rate conservative. The implied rule in that case is a Taylor-type rule where the instrument is in first-differences.

Suggested Citation

  • Timothy Kam, 2003. "Optimal Flexible Inflation Targeting, Interest-rate Smoothing and the Open Economy," Economics Discussion / Working Papers 03-26, The University of Western Australia, Department of Economics.
  • Handle: RePEc:uwa:wpaper:03-26
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    References listed on IDEAS

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    More about this item

    Keywords

    Interest-rate smoothing; monetary policy; business cycle fluctuations; sticky prices; small open economy; stabilization bias;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • 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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