International Trade Openness and Monetary Policy: Evidence from Cross-Country Data

Abstract

This article studies the extent to which open economies conduct monetary policy differently from economies that are relatively closed to international trade. I first estimate country-specific Taylor rules for 26 economies, following the approach of Clarida, Gal, and Gertler (1998 and 2000). Then, I examine the extent to which open economies assign systematically different weights to changes in economic outcomes, such as inflation and the output gap, than their closed economy counterparts do. I find that open economies respond less strongly to changes in expected inflation than relatively closed economies do and that the response to changes in the output gap is independent of the degree of trade openness. Moreover, I find that this difference between closed and open economies may be accounted for by the higher weight open economies give to changes in the real exchange rate, whereby these economies are more likely to decrease the nominal interest rate when the real exchange rate is relatively appreciated.