Monetary policy rules for an open economy

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 02 January 2002

Working Paper no. 149
Nicoletta Batini, Richard Harrison and Stephen P Millard

The most popular simple rule for the interest rate, due to Taylor (1993a), is meant to inform monetary policy in economies that are closed. On the other hand, its main open-economy alternative, ie Ball’s (1999) rule based on a monetary conditions index (MCI), may perform poorly in the face of specific types of exchange rate shocks and thus cannot offer guidance for the day-to-day conduct of monetary policy. In this paper we specify and evaluate a comprehensive set of simple monetary policy rules that are suitable for small open economies in general, and for the United Kingdom in particular. We do so by examining the performance of a battery of simple rules, including the familiar Taylor rule and MCI-based rules à la Ball. This entails comparing the asymptotic properties of a two-sector open-economy dynamic stochastic general equilibrium model calibrated on UK data under different rules. We find that an inflation-forecast-based rule (IFB), ie a rule that reacts to deviations of expected inflation from target, is a good simple rule in this respect. Adding a separate response to the level of the real exchange rate (contemporaneous and lagged) appears to reduce the difference in adjustment between output gaps in the two sectors of the economy, but the improvement is only marginal. Importantly, an IFB rule, with or without exchange rate adjustment, appears robust to different shocks, in contrast to naïve or Ball’s MCI-based rules.

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