Caution or Activism? Monetary Policy Strategies in an Open Economy

31 Pages Posted: 15 Feb 2005

See all articles by Martin Ellison

Martin Ellison

University of Oxford

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Jouko Vilmunen

Bank of Finland, Research Unit

Date Written: November 2004

Abstract

We examine optimal policy in a two-country model with uncertainty and learning, where monetary policy actions affect the real economy through the real exchange rate channel. Our results show that whether policy should be cautious or activist depends on the size of one country relative to another. If one country is small relative to the other, then activism is optimal. In contrast, if the two countries are equal sized, then caution prevails. Caution is induced in the latter case because of the interaction between the home and foreign central banks. In a two-country symmetric equilibrium, learning is shown to be detrimental to welfare, implying that optimal policy is cautious.

Keywords: Monetary policy, open economy, learning

JEL Classification: E52, E58, F41

Suggested Citation

Ellison, Martin and Sarno, Lucio and Vilmunen, Jouko, Caution or Activism? Monetary Policy Strategies in an Open Economy (November 2004). CEPR Discussion Paper No. 4766, Available at SSRN: https://ssrn.com/abstract=666807

Martin Ellison (Contact Author)

University of Oxford ( email )

Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom

Lucio Sarno

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Jouko Vilmunen

Bank of Finland, Research Unit ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

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