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Determinacy and Learnability of Monetary Policy Rules in Small Open Economies

Authors


  • We are grateful to Pierpaolo Benigno, Guillermo Calvo, Paul Castillo, Stefano Eusepi, Alejandro Izquierdo, Norman Loayza, Kaushik Mitra, Carlos Montoro, Marco Vega, Carl Walsh, two anonymous referees, and seminar participants at the North American Econometric Society 2006, the Banco Central de Reserva del Perú, and the IDB for helpful suggestions and comments. We also would like to thank James Bullard, who provided us an earlier manuscript of the paper “Determinacy, Learnability, and Monetary Policy Inertia.” The views expressed in this paper are those of the authors and do not necessarily reflect the views of the Banco Central de Reserva del Perú. Any errors are our own responsibility.

Abstract

This paper evaluates under which conditions different Taylor-type rules lead to determinacy and expectational stability (E-stability) of rational expectations equilibrium in a simple “New Keynesian” small open economy model, developed by Gali and Monacelli (2005). In particular, we extend Bullard and Mitra (2002) results of determinacy and E-stability in a closed economy to this small open economy framework. Our results highlight an important link between the Taylor principle and both determinacy and learnability of equilibrium in small open economies. More importantly, the degree of openness coupled with the nature of the policy rule adopted by the monetary authorities might change this link in important ways. A key finding is that, contrary to Bullard and Mitra, expectations-based rules that involve the consumer price inflation and/or the nominal exchange rate limit the region of E-stability and the Taylor Principle does not guarantee E-stability. We also show that some forms of managed exchange rate rules can help to alleviate problems of both indeterminacy and expectational instability, yet these rules might not be desirable since they can promote greater volatility in the economy.

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