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OPTIMAL MONETARY POLICY IN AN OPEN ECONOMY

Raf Wouters () and Frank Smets

No 186, Computing in Economics and Finance 2000 from Society for Computational Economics

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.

Date: 2000-07-05
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More papers in Computing in Economics and Finance 2000 from Society for Computational Economics CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain. Contact information at EDIRC.
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