RDP 9806: Policy Rules for Open Economies 1. Introduction

What policy rules should central banks follow? A growing number of economists and policy-makers advocate targets for the level of inflation. Many also argue that inflation targeting should be implemented through a ‘Taylor rule’ in which interest rates are adjusted in response to output and inflation. These views are supported by the theoretical models of Svensson (1997a) and Ball (1997), in which the optimal policies are versions of inflation targets and Taylor rules.

Many analyses of policy rules assume a closed economy. This paper extends the Svensson-Ball model to an open economy and asks how the optimal policies change. The short answer is they change quite a bit. In open economies, inflation targets and Taylor rules are suboptimal unless they are modified in important ways. Different rules are required because monetary policy affects the economy through exchange rate as well as interest-rate channels.[1]

Section 2 presents the model, which consists of three equations. The first is a dynamic, open-economy IS equation: output depends on lags of itself, the real interest rate, and the real exchange rate. The second is an open-economy Phillips curve: the change in inflation depends on lagged output and the lagged change in the exchange rate, which affects inflation through import prices. The final equation is a relation between interest rates and exchange rates that captures the behaviour of asset markets.

Section 3 derives the optimal instrument rule in the model. This rule differs in two ways from the Taylor rule that is optimal in a closed economy. First, the policy instrument is a weighted sum of the interest rate and the exchange rate – a ‘Monetary Conditions Index’ like the ones used in several countries. Second, on the right side of the policy rule, inflation is replaced by ‘long-run inflation’. This variable is a measure of inflation adjusted for the temporary effects of exchange-rate fluctuations.

Section 4 considers several instrument rules proposed in other papers at this conference. I find that most of these rules perform poorly in my model.

Section 5 turns to inflation targeting. In the closed-economy models of Svensson and Ball, a simple version of this policy is equivalent to the optimal Taylor rule. In an open economy, however, inflation targeting can be dangerous. The reason concerns the effects of exchange rates on inflation through import prices. This is the fastest channel from monetary policy to inflation, and so inflation targeting implies that it is used aggressively. Large shifts in the exchange rate produce large fluctuations in output.

Section 6 presents a more positive result. While pure inflation targeting is undesirable, a modification produces much better outcomes. The modification is to target ‘long-run inflation’ – the inflation variable that appears in the optimal instrument rule. This variable is not influenced by the exchange-rate-to-import-price channel, and so targeting it does not induce large exchange-rate movements. Targeting long-run inflation is not exactly equivalent to the optimal instrument rule, but it is a close approximation for plausible parameter values.

Section 7 concludes the paper.


Svensson (1997b) also examines alternative policy rules in an open-economy model. That paper differs from this one and from Svensson (1997a) in stressing microfoundations and forward-looking behaviour, at the cost of greater complexity. [1]