The Conduct of Global Monetary Policy and Domestic Stability

Abstract

The purpose of this paper is to examine how important an improvement in global monetary policy might be for the macroeconomic performance of a small open economy such as the United Kingdom. Our paper contributes to the literature by proposing a new methodology to treat indeterminate solutions (the most-robust solution), and by analysing a policy improvement within a three-country framework. Both contributions yield a rich set of theoretical and policy implications. We find that the performance of the domestic macroeconomy depends crucially on domestic monetary policy, but there remains significant potential for monetary policy abroad to improve the stability of inflation and output in a small open economy. Importantly, how much of this potential spillover from policy abroad crystallises is still endogenous to the conduct of domestic policy. We also show that an improvement in policy abroad may not reduce domestic volatility when domestic policy is the only poor policy globally. In such a case domestic volatility can even become worse. Our paper also yields interesting results related to the impact of a policy improvement abroad on inflation persistence in the domestic economy and her exposure to foreign shocks.

Keywords: Indeterminacy, stochastic volatility, Taylor rule, international spillovers, Great Inflation

JEL Classification: C62, D84, E30, E58, E61, F41, F42