This paper examines the choice of a monetary-policy rule in a simple macroeconomic model. In a closed economy, the optimal policy is a output and inflation. In an open economy, the optimal rule changes in two ways. First, the policy instrument is a Conditions Index the exchange rate. Second, on the right side of the rule, inflation is replaced by filters out the transitory effects of exchange-rate movements. The model also implies that pure inflation targeting is dangerous in an open economy, because it creates large fluctuations in exchange rates and output. Targeting long-run inflation avoids this problem and produces a close approximation to the optimal instrument rule.

This timely volume presents the latest thinking on the monetary policy rules and seeks to determine just what types of rules and policy guidelines function best. A unique cooperative research effort that allowed contributors to evaluate different policy rules using their own specific approaches, this collection presents their striking findings on the potential response of interest rates to an array of variables, including alterations in the rates of inflation, unemployment, and exchange. Monetary Policy Rules illustrates that simple policy rules are more robust and more efficient than complex rules with multiple variables. A state-of-the-art appraisal of the fundamental issues facing the Federal Reserve Board and other central banks, Monetary Policy Rules is essential reading for economic analysts and policymakers alike.

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.

This essay discusses rules for monetary policy in open economies. If policymakers seek to stabilize output and inflation, optimal rules in open economies differ considerably from optimal rules in closed economies. In open economies, stability is best achieved by targeting long-run inflation' a measure of inflation adjusted to remove transitory effects of exchange-rate movements. Stability is also enhanced by adding an exchange-rate term to "Taylor rules" for setting interest rates. Finally, central banks must choose whether their policy instrument is an interest rate or a "monetary conditions index": an average of the interest rate and the exchange rate. The nature of shocks to the exchange rate determines which of these choices keeps output and inflation more stable.

This paper asks whether inflation targeting improves economic performance, as measured by the behavior of inflation, output, and interest rates. We compare seven OECD countries that adopted inflation targeting in the early 1990s to thirteen that did not. After the early 90s, performance improved along many dimensions for both the targeting countries and the non-targeters. In some cases the targeters improved by more; for example, average inflation fell by a larger amount. However, these differences are explained by the facts that targeters performed worse than non-targeters before the early 90s, and there is regression to the mean. Once one controls for regression to the mean, there is no evidence that inflation targeting improves performance.

One distinguishable characteristic of emerging market economies is that they are not financially robust. These economies are incapable of smoothing out large external shocks, as sudden capital outflows imply large and abrupt swings in the real exchange rate. Using a small open-economy model, this paper examines alternative monetary policy rules for economies with different degrees of liability dollarization. The paper answers the question of how efficient it is to use inflation targeting under high liability dollarization. Our findings suggest that it might be optimal to follow a nonlinear policy rule that defends the real exchange rate in a financially vulnerable economy.

We evaluate the expectational stability (E-stability) of rational expectations equilibrium in a simple "New Keynesian" small open economy model. In particular, we extend Bullard and Mitra (JME, 2002) results of E-stability in closed economy to an open economy framework by evaluating Taylor-type rules. The main results are the following: a) the stability conditions under learning in open economies are isomorphic to the closed economy counterpart when the central bank targets contemporaneously either domestic price inflation or CPI inflation; b) the problem of instability under learning becomes more serious in open economies when the central bank reacts actively to expected consumer price inflation (CPI). Thus, unlike Bullard and Mitra (2002) the Taylor's principle does not necessarily induce both determinate and learnable rational expectation equilibria, where the degree of openness plays a crucial role c) it is easier for the economy to get into an unstable region when a central bank reacts to expected movements in the exchange rate along with an actively reaction to expected CPI inflation.

United States monetary policy has traditionally been modeled under the assumption that the domestic economy is immune to international factors and exogenous shocks. Such an assumption is increasingly unrealistic in the age of integrated capital markets, tightened links between national economies, and reduced trading costs. International Dimensions of Monetary Policy brings together fresh research to address the repercussions of the continuing evolution toward globalization for the conduct of monetary policy. In this comprehensive book, the authors examine the real and potential effects of increased openness and exposure to international economic dynamics from a variety of perspectives. Their findings reveal that central banks continue to influence decisively domestic economic outcomes—even inflation—suggesting that international factors may have a limited role in national performance. International Dimensions of Monetary Policy will lead the way in analyzing monetary policy measures in complex economies.