Policy Rules for Open Economies

Laurence Ball

RBA Research Discussion Papers from Reserve Bank of Australia

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.

Keywords: monetary policy rules; inflation targeting (search for similar items in EconPapers)
JEL-codes: E52 F41 (search for similar items in EconPapers)
Date: 1998-07
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Citations: View citations in EconPapers (128)

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Related works:
Chapter: Policy Rules for Open Economies (1999)
Working Paper: Policy Rules for Open Economies (1998)
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Persistent link: https://EconPapers.repec.org/RePEc:rba:rbardp:rdp9806

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