Monetary Policy Rules for Convergence to the Euro

Abstract:     
This paper investigates the applicability of open-economy convergence-consistent instrument rules for monetary policies in the economies undergoing monetary convergence to a common currency area. The proposed policy rule is forward-looking, consistent with a monetary framework based on inflation-targeting containing input variables that are relative to the corresponding variables in the common currency area. Robust forms of the policy rule are tested empirically for three inflation-targeting countries converging to the euro, i.e. the Czech Republic, Poland and Hungary. Empirical tests imply systemic differences in monetary policies among these euro candidates. The Czech monetary policy seemingly follows the rule prescribed by our model. Both the Czech and the Polish central bank interest rate policies respond predominantly to changes in the inflation gap, while the Hungarian responds mainly to the exchange rate gap. In all three cases, changes in the Eurozone short-term interest rates strongly drive adjustments in the central banks’ reference interest rates.

Keywords: Monetary convergence, Taylor rules, Inflation targeting

JEL Classification: E43, E52, F36

Accepted Paper Series