Monetary Policy Rules for Convergence to the Euro

Abstract:     
This paper aims to devise a monetary policy instrument rule that is suitable for open economies undergoing monetary convergence to a common currency area. The open-economy convergence-consistent Taylor rule is forward-looking, consistent with monetary framework based on inflation targeting, containing input variables that are relative to the corresponding variables in the common currency area. The policy rule is tested empirically for three inflation targeting countries converging to the euro, i.e. the Czech Republic, Poland and Hungary. Stability tests of the input variables affirm prudent inclusion of these variables in the suggested policy rule. Empirical tests of the proposed instrument rule point to systemic differences in monetary policies among these euro-candidates. The Czech inflation targeting is forwardlooking relying on a sensible balance between inflation and output growth objectives. Poland’s policy focuses on backward-looking inflation, while the Hungarian policy on exchange rate stability. Forecasts of policy instruments based on the prescribed rule are more accurate and reliable for the Czech Republic and Hungary, but less for Poland.

Number of Pages in PDF File: 30

Keywords: monetary convergence, Taylor rules, inflation targeting

JEL Classification: E43, E52, F36

working papers series