Caution or Activism? Monetary Policy Strategies in an Open Economy

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