Reflections on Monetary Policy in the Open Economy

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Introduction

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Taylor Rule Exchange Rate Forecasting during the Financial Crisis

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This chapter presents the basic concepts of open economy macroeconomics. Sections 8.1 and 8.2 discuss arbitrage-pricing models for goods and services in international trade and for interest rates in the capital flow between countries. Section 8.3 introduces the Marshall-Lerner condition, which sets a condition for a positive correlation between the terms of trade and the current account on the balance of payments. Section 8.4 addresses the specification of the IS curve in an open economy; showing the relationship between real output, real interest rate, and real exchange rate. The specifications of the IS curves are shown for the traditional and the new Keynesian models. Section 8.5 analyzes the determination of the long-term equilibrium real exchange rate, the natural exchange rate. Section 8.6 discusses the specification of the Taylor Rule in an open economy. Section 8.7 covers the specification of the Phillips curve in an open economy in the Keynesian and new Keynesian models.

1. IntroductionThis article examines the relationship between economic and inflation performance. Among the most prominent research on this topic is the work by Romer (1993). He demonstrates a negative relationship between economic and the inflation level. His finding has also been viewed as supportive, albeit indirectly, of time consistency theory (Kydland and Prescott 1977).1 Romer (1993) argues that policymakers in more open economies have less incentive to adopt an expansionary monetary policy. His argument is based on the assumption that monetary surprises in more open economies result in higher inflation for a given increase in output. Romer's finding that more open economies have lower inflation levels leads him to infer that this is evidence of time consistency in monetary policy practices.However, Romer's work has not been generally accepted. Temple (2002) provides evidence that the openness-inflation correlation does not stem from time consistency theory because the inflation level may not properly reveal the monetary authorities' policy intentions. Temple questions this inference because it starts from a strong but unjustified assumption--more open economies possess a relatively steeper Phillips curve. Consequently, Temple proposes that the examination of the positive relationship between and the slope of the Phillips curve is a fundamental condition for Romer's argument. He, however, finds little support for the positive relationship between economic and the slope of the Phillips curve.Further work on the relationship of and monetary policy intentions comes from Clarida, Gali, and Gertler (2001, 2002; hereafter CGG). In CGG (2001), the authors present a simple open-economy model with a Taylor-type interest rate policy rule (Taylor 1993). The article concludes that the optimal monetary policy in an open economy has the same solution as that in a closed economy derived in CGG (1999). The authors also suggest that there is a direct link between the degree of economic and the aggressiveness of monetary policy. They state that, [O]penness does affect the parameters of the model, suggesting a quantitative implication. ... [H]ow aggressively a central bank should adjust the interest rate in response to inflationary pressures depends on the degree of openness (CGG 2001, p. 248).In subsequent work, CGG (2002) revisit the issue based on a dynamic open-economy New Keynesian model and the role of monetary policy in open economies is refined. Consistent with the argument in CGG (2001), they find that the optimal monetary policy rule in an open economy is isomorphic to that in a closed economy in the Nash equilibrium. They also suggest that does not affect the optimality of a policy rule in such a scenario. On the other hand, economic does affect optimal monetary policy when the foreign optimal policy is endogenous in the domestic country's objective function. This effect, however, is ambiguous in direction because the relationship between the degree of economic and the aggressiveness of monetary policy is determined by the relative size of trade and wealth effects of changes in foreign output.This line of theoretical literature is limited and does not offer a definitive conclusion on the relationship between economic and monetary policy intentions. Our article provides an alternative empirical evaluation of the relationship. Based on prior literature, we use inflation variability and persistence as the measures of monetary policy intentions. One branch of the literature, such as Taylor (1999), CGG (2000), and Owyang (2001), argues that aggressive monetary policy reduces the volatility of inflation. For instance, CGG (2000) estimate a forward-looking Taylor rule for the period between 1960:I and 1996:IV. They use Paul Volcker's appointment as Chairman of the Federal Reserve System as a regime shift to a more aggressive anti-inflation policy stance. …

IntroductionRecent Developments in Monetary Macroeconomics David Altig The contents of this volume hardly require explanation beyond its title: "Recent Developments in Monetary Macroeconomics." Our intent for the conference was to collect a set of papers reflecting the cutting edge of applied monetary macroeconomics. As befitting such an ambitious-sounding goal, the contributions are wide ranging. For purposes of this brief introduction, however, we might organize the papers as answers to three questions. (1) What is the "optimal" Taylor rule? (2) Are "New Keynesian" or "New Neoclassical Synthesis" models the final word on the monetary transmission mechanism? (3) Is there a role for money in the conduct of monetary policy? What is the "Optimal" Taylor Rule The inclusion of the Taylor rule issue is almost a prerequisite for any collection of papers purporting to survey recent developments in monetary macroeconomics. In policy discussions, the Taylor rule is ubiquitous, and it is currently the choice among alternative specifications of central bank behavior. More precisely, perhaps, the general form of the Taylor rule is the choice, as it has come to represent the general class of equations that relate the federal funds rate to some measure of an output gap and inflation rate. There is substantially less unanimity about whether output gaps and inflation rates should be past, present, or (expected) future values, whether past values of the funds rate need to be included, and what are the appropriate magnitudes of the responses to each of these measures. Marc Giannoni and Michael Woodford offer the natural approach to addressing the dispute: find the representation that is optimal within the framework being employed for policy analysis. The model in question here is essentially a derivative of the "New Neoclassical Synthesis" class of models that are currently the workhorses of most monetary policy analyses among academic and central bank staffs alike. Their approach to discovering the optimal policy within this structure has the flavor of [End Page 1039] the "Ramsey problem" familiar from optimal tax policy, although with the strong requirement that the derived policy rule be "robustly optimal": it must support the optimal equilibrium no matter what the distribution of disturbances the model policymakers face. Giannoni and Woodford offer two essential lessons. First, whether optimal policy incorporates forecasts of future price-level growth or output gaps depend critically on the dynamics of the inflation rate. If the adjustment of the price-level to shocks is inertial, then optimal policy necessarily depends on forecasts of future inflation. Second, the response of the funds rate to its own past is inertial. In fact, it is super-inertial, meaning that (all else equal), the contemporaneous funds rate responds more than one-for-one with the lagged value of the funds rate (and lagged changes in the rate). The proposition that monetary authorities ought to aggressively respond to lagged values of the funds rate also arises in the papers by Jess Benhabib, Stephanie Schmitt-Grohé, and Martín Uribe, and George Evans and Seppo Honkapohja. In the latter case, the authors consolidate and expand on their well-known work on learning dynamics. A central contribution of the work presented in this article is the notion that convergence to a unique rational expectations equilibrium under learning, as well as the stability of that equilibrium, serves as basis for the choice (or rejection) of an optimal policy formulation. An apparent lesson from Evans and Honkapohja's analysis is that the learnability criterion prescribes a policy rule that differs in some important ways from the conventional wisdom coming from analyses that invoke the Taylor rule in a pure rational expectations environment. In particular, they conclude that the optimal policy rule in the environment they consider requires the monetary authority to respond directly to private-sector expectations. The environment they consider is essentially the same as in Giannoni and Woodford, with the exception of the central bank's assumed loss function: Giannoni and Woodford assume a preference for interest rate smoothing, Evans and Honkapohja do not. In his comments, John Duffy points out that the introduction of interest-smoothing motive yields an optimal policy rule under learning that is much closer to the conventional view. In particular, it does not require...

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In this article, we study the optimal simple monetary policy rules under the Zero Lower Bound using DSGE model. The model economy is open and highly dependent on the terms of trade. Economic dynamics is the result of a terms of trade shock and an external interest rate shock. Using the impulse response functions, we show that the presence of ZLB reduces the impact of positive external shocks. This means greater growth in real interest rates and less growth in consumption and production. Monetary authority minimizes the volatility of key macroeconomic indicators. The optimal parameters of the rule turn out to be such that the regulator de facto reduces the probability of being at the ZLB. Under the ZLB the regulator is less responsive to inflation changes, and the interest rate is more persistent. In the case of Russia, we have got low probability estimate of hitting the ZLB under the current monetary policy and a long-term value of the interest rate of 6%. The gap reaction parameter and interest rate persistence parameter for the current monetary policy are in the range of values for optimal monetary policy rules. The current CPI reaction parameter is much less than the optimal one. This implies a higher probability of hitting the ZLB in the optimum than under the current monetary policy. The results obtained can be used by the regulator to assess the limits of the application of monetary policy and adjust the monetary policy by taking into account the possibility of reaching the ZLB. [In Russian] В работе с помощью динамической стохастической модели общего равновесия исследуются правила денежно-кредитной политики при условии наличия нижней нулевой границы ставок. Модельная экономика является открытой и сильно зависящей от условий торговли. Экономическая динамика является результатом действия шока условий торговли и шока внешней процентной ставки. На уровне функций импульсного отклика показано, что наличие нижней границы ставок приводит к уменьшению влияния позитивных внешних шоков: к большему росту реальных процентных ставок и к меньшему росту потребления и выпуска. Были найдены оптимальные правила ДКП, реализующие стремление органа ДКП минимизировать волатильность ключевых макроэкономических показателей. В оптимуме параметры правила оказываются такими, что регулятор де-факто уменьшает вероятность пребывания на нижней границе ставок. При наличии ограничения нижней границы ставок регулятору выгоднее в меньшей степени реагировать на изменение инфляции и в большей мере сглаживать во времени динамику процентной ставки. Для России вероятность попадания на нулевую границу ставок при текущей денежно-кредитной политике и долгосрочном значении процентной ставки 6% в результате действия внешних шоков была оценена как низкая. Действующее правило ДКП в отношении реакция процентной ставки на разрыв выпуска и сглаживания во времени динамики процентной ставки попадает в диапазон значений из оптимальных правил, тогда как текущая степень реакции на инфляцию оказывается значительно ниже оптимальных параметров, что подразумевает более высокую вероятность попадания на границу ставок в оптимуме. Результаты работы могут быть использованы регулятором для оценки границ применения ДКП и корректировки ДКП с учётом возможности попадания на нижнюю границу процентных ставок.

We analyse optimal monetary and fiscal policy in a New-Keynesian model with public debt and inflation persistence. Leith and Wren-Lewis (2007) have shown that optimal discretionary policy is subject to a 'debt stabilization bias' which requires debt to be returned to its pre-shock level. This finding has two important implications for optimal discretionary policy. Firstly, as Leith and Wren-Lewis have shown, optimal monetary policy in an economy with high steady-state debt cuts the interest rate in response to a cost-push shock - and therefore violates the Taylor principle. We show that this striking result is not true with high degrees of inflation persistence. Secondly, we show that optimal fiscal policy is more active under discretion than commitment at all degrees of inflation persistence and all levels of debt.

We analyse optimal monetary and fiscal policy in a New-Keynesian model with public debt and inflation persistence. Leith and Wren-Lewis (2007) have shown that optimal discretionary policy is subject to a 'debt stabilization bias' which requires debt to be returned to its pre-shock level. This finding has two important implications for optimal discretionary policy. Firstly, as Leith and Wren-Lewis have shown, optimal monetary policy in an economy with high steady-state debt cuts the interest rate in response to a cost-push shock - and therefore violates the Taylor principle. We show that this striking result is not true with high degrees of inflation persistence. Secondly, we show that optimal fiscal policy is more active under discretion than commitment at all degrees of inflation persistence and all levels of debt.

In this study, we estimated and simulated an NKDSGE model for Algeria based on the method through which a small open economy should react to economic. The model consists of hybrid equations for the IS curve, Phillips curve, exchange rate equation and monetary policy based on Taylor's type. We estimated the system of equations by the BVAR technique on quarterly Algerian macroeconomic data from 2000 to 2018. We have then used the estimated parameter values in the simulation to capture the impact of foreign shocks for: inflation, output, technology, trade terms and monetary policy on the Algerian macroeconomic. The results confirmed that all foreign shocks contributed to the fluctuations of domestic GDP, domestic inflation and exchange rate through simultaneous economic cycles between 2-4 years except the worldwide output shock, which lasted about 10 years. The monetary rule appeared to play its role each time with a faithful memory of the historical interest rate without giving much weight to the exchange rate, domestic output and inflation.

This paper investigates optimal stabilization policy in a small open economy using a continuous time model in which inflation depends on future monetary policy as well as past inflation. The impact of monetary policy is assumed to operate via real interest rates and the real exchange rate and the setting of real interest rates is chosen so as to minimize quadratic costs of fluctuations in output and inflation, subject to varying expectations in the foreign exchange market. Analytical expressions and simulation results are presented for "time inconsistent" optimal policy, the "dynamic programming" solution, for policy which ignores the exchange rate effects when setting real interest rates, and for the "optimal linear feedback" rule.