The Performance of Simple Monetary Policy Rules in a Large Open Economy

Abstract

This paper examines the performance of simple monetary policy rules in a two country open economy model under both cooperative and non cooperative settings. In particular, it examines the extent to which simple policy rules with external variables and simple policy rules under policy coordination can help improve an adversely affected economy: one that faces greater persistence of inflation, higher volatility of shocks, and a greater vulnerability to exchange rate fluctuations.

We isolate the impact of individual asymmetries through simulations that introduce differences into two, otherwise symmetric, economies. The paper shows that the results vary according to the underlying cause of the adverse performance. Greater inflation persistence and higher volatility of shocks irreversibly worsen macroeconomic outcomes while greater external vulnerability affect the distribution of cooperative gains: the less-insulated economy benefits at the expense of the more-insulated economy. Furthermore, the reaction coefficients in the simple policy rules behave in an intuitive fashion: both policy cooperation and reaction to external shocks substantially attenuate the reaction coefficients on inflation and unemployment.

JEL Classification: E52, E58, F41