Monetary Policy Rules for an Open Economy

Bank of England Working Paper No. 149

51 Pages Posted: 15 Jan 2002

See all articles by Nicoletta Batini

Nicoletta Batini

International Monetary Fund (IMF)

Richard Harrison

Bank of England - Monetary Analysis

Stephen Millard

Bank of England

Date Written: December 2001

Abstract

The most popular simple rule for the interest rate, due to Taylor, is meant to inform monetary policy in closed economies. On the other hand, its main open-economy alternative, Ball's rule based on a monetary conditions index (MCI), may perform poorly in the face of specific types of exchange rate shocks, and thus cannot offer guidance for the day-to-day conduct of monetary policy. In this paper, a comprehensive set of simple monetary policy rules (including the MCI-based and Taylor versions) is specified and evaluated, all suitable for small open economies in general, and for the United Kingdom in particular. The asymptotic properties of a two-sector open-economy dynamic stochastic general equilibrium model calibrated on UK data are compared under the different rules. It is found that an inflation-forecast-based rule (IFB), i.e., one that reacts to deviations of expected inflation from target, performs well. Adding a separate response to the level of the real exchange rate (contemporaneous and lagged) appears to reduce the difference in adjustment between output gaps in the two sectors of the economy, but the improvement is only marginal. Importantly, an IFB rule, with or without exchange rate adjustment, appears robust to different shocks, in contrast to naive or Ball's MCI-based rules.

Suggested Citation

Batini, Nicoletta and Harrison, Richard and Millard, Stephen, Monetary Policy Rules for an Open Economy (December 2001). Bank of England Working Paper No. 149. Available at SSRN: https://ssrn.com/abstract=296823 or http://dx.doi.org/10.2139/ssrn.296823

Nicoletta Batini (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Richard Harrison

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Stephen Millard

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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