Openness and Equilibrium Determinacy Under Interest Rate Rules

43 Pages Posted: 14 Jan 2003

See all articles by Fiorella De Fiore

Fiorella De Fiore

Bank for International Settlements (BIS) - Monetary and Economic Department

Zheng Liu

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Date Written: September 2002

Abstract

This paper shows that the conditions under which inflation-targeting interest rate rules lead to equilibrium uniqueness in a small open economy in general differ from those in a closed economy. As the monetary authority adjusts nominal interest rates in response to inflation, the real interest rate changes. The overall effect of this change on aggregate demand has important implications for equilibrium determinacy. In an open economy, an increase in the real interest rate is transmitted to aggregate demand through an intertemporal substitution effect, as in a closed economy, but also through a terms of trade effect that is absent in the closed economy. These effects move aggregate demand in opposite directions. We find that, in a broad class of models, the conditions for local equilibrium uniqueness depend crucially on the degree of openness to international trade. Openness matters not only quantitatively, but also qualitatively.

Keywords: Indeterminacy, Interest Rate Rules, Small Open Economy, Terms of Trade

JEL Classification: E52, E58, F41

Suggested Citation

De Fiore, Fiorella and Liu, Zheng, Openness and Equilibrium Determinacy Under Interest Rate Rules (September 2002). Available at SSRN: https://ssrn.com/abstract=358106 or http://dx.doi.org/10.2139/ssrn.358106

Fiorella De Fiore (Contact Author)

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Zheng Liu

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States