Robust monetary policies in small open economies

Abstract

Recent research on model uncertainty has focused mainly on closed economies. Levin and Williams confirm the existence of robust rules across competing closed economy models. In this paper, we evaluate three small open economy models exhibiting different degrees of inflation and output gap persistence. We find that the above result does not carry over to the open economy, primarily due to the mutually exclusive degree of interest rate smoothing that yields stability in the three models. We also confirm the existence of robust rules across the closed economy versions of these models. Finally, a first difference rule, though yields dynamic stability across the open economy models, continues to perform poorly in at least one of the models. Thus, the cost of choosing the wrong model is extremely high in open economies compared to closed economies, and policymakers must invest more resources to know the true structure of these economies. Copyright 2010 Oxford University Press 2009 All rights reserved, Oxford University Press.