Monetary policy rules for an open economy

Abstract

The popular Taylor rule is meant to inform monetary policy in economies that are closed. Its main open-economy alternative, i.e., Ball's (In: J.B. Taylor (Ed.), Monetary Policy Rules, University of Chicago Press, Chicago) rule based on a Monetary Conditions Index, cannot offer guidance for the day-to-day conduct of monetary policy because it may perform poorly in the face of specific exchange rate shocks. In this paper we examine the performance of various monetary policy rules suitable for small open economies vis-à-vis existing rules. This entails comparing the asymptotic properties of a two-sector open-economy dynamic stochastic general equilibrium model calibrated on UK data under different rules. We find that an inflation-forecast-based rule is a good rule in this respect, one that also proves robust to different shocks. Adding a separate response to the level of the real exchange rate improves stabilisation only marginally.