This article sets out a simple New Keynesian open-economy model and shows that the conduct of discretionary monetary policy in an open economy differs substantially from the closedeconomy framework. The article shows analytically that the existence of the direct exchange rate channel in the open economy Phillips Curve impairs the perfect stabilising property of monetary policy in the face of demand-side disturbances under domestic inflation targeting. If CPI inflation is instead the target, then the perfect stabilising property of monetary policy breaks down even in the absence of the direct exchange rate channel in the Phillips Curve.In small open economies, the pricing decisions of domestic firms are affected by movements in the exchange rate and other developments abroad, such as changes in the pricing behaviour of foreign firms. This is well-understood. The challenge is to show how domestic producers react to these changes. This article introduces an open economy Phillips Curve that is derived on the assumption that domestic firms adjust their optimal product price in line with changes in the domestic currency price of the foreign consumption good. The characterising feature of this open economy Phillips Curve is the presence of the real exchange rate.The existence of a direct real exchange rate channel in the Phillips Curve has an important consequence for the conduct of discretionary monetary policy in the open economy: the perfect stabilising property of discretionary monetary policy in the wake of demand-side disturbances and exchange rate disturbances under flexible domestic inflation targeting disappears. 1 Both domestic inflation and real output deviate from their respective target in the face of such disturbances because the change in the policy instrument causes a change in the real exchange rate that in turn has a direct effect on domestic inflation. This result contrasts sharply with the stabilising features of optimal policy in more conventional open and closed economy models where the policy maker need merely adjust the setting of the policy instrument to control aggregate demand. These standard models feature a conventional Phillips curve where domestic inflation responds to expected future inflation, the output gap, a cost-push shock but not to the real exchange rate. As a result, the policy maker is unable to stabilise the economy perfectly only in the face of cost-push shocks. 2
Abstract:Examining three flexible inflation targeting strategies, we find that a small concern for real exchange rate stability as a policy goal matters. First, it warrants the inclusion of the real exchange rate in Taylor rules and, second, it is sufficient to improve the performance of Taylor rules relative to optimal policy. Gains are substantial for domestic and REX inflation targets because a small weight on real exchange rate fluctuations makes optimal policy less aggressive. The gains under CPI inflation targeting are considerably lower.
This paper examines the role of credit providers in the EMU and assesses the effects of credit spreads and credit quantities on economic activity. Movements in credit spreads are far more successful than movements in the external finance mix in predicting near-term changes in real economic activity in ten EMU countries. However, the forecasting performance of the three credit spreads evaluated in this paper is uneven. A risk premium extracted from individual corporate bond yields predicts three measures of economic activity fairly well in Germany and Southern Europe. Two other credit spreads, the 'spread' and the 'ECB-spread', have predictive power for some measures of economic activity but they fail to predict consistently across either a range of economic indicators or countries.
This paper examines the relative merits of alternative monetary policy rules for a small open economy. Rules considered target: the exchange rate, price level, nominal income, or a monetary aggregate. The standard framework employed in previous comparisons of these rules fails to take account of important features of small open economies. In particular, the standard framework fails to consider the effects on aggregate supply of exchange rate adjustments resulting from adherence to policy rules. Incorporating these effects is shown to weaken the case for targeting nominal income and, more generally, to complicate the ranking of policy rules.
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