Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach

Abstract

In Clarida et al. (1999; hereafter CGG), we presented a normative analysis of monetary policy within a simple optimization-based closedeconomy framework. We derived the optimal policy rule and, among other things, characterized the gains from commitment. Also, we made precise the implications for the kind of instrument feedback rule that a central bank should follow in practice. In this paper we show how our analysis extends to the case of a small open economy. Openness complicates the problem of monetary management to the extent the central bank must take into account the impact of the exchange rate on real activity and inflation. How to factor the exchange rate into the overall design of monetary policy accordingly becomes a central consideration. Here we show that, under certain conditions, the monetary-policy design problem for the small open economy is isomorphic to the problem of the closed economy that we considered earlier. Hence, all our qualitative results for the closed economy carry over to this case. Openness does affect the parameters of the model, suggesting quantitative implications. Though the general form of the optimal interest-rate feedback rule remains the same as in the closedeconomy case, for example, how aggressively a central bank should adjust the interest rate in response to inflationary pressures depends on the degree of openness. In addition, openness gives rise to an important distinction between domestic inflation and consumer price inflation (as defined by the CPI). To the extent that there is perfect exchange-rate pass-through, we find that the central bank should target domestic inflation and allow the exchange rate to float, despite the impact of the resulting exchangerate variability on the CPI (Kosuki Aoki, 1999; Gali and Tommaso Monacelli, 2000).