Testing Monetary Policy Intentions in Open Economies

Abstract

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. …