DP3279 Monetary Policy Rules in the Open Economy: Effects on Welfare and Business Cycles

Author(s): Robert Kollmann
Publication Date: March 2002
Keyword(s): business cycles, interest rate rules, Open economy
JEL(s): E40, F30, F40
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3279

This Paper computes welfare maximizing Taylor-style interest rate rules, in a business cycle model of a small open economy. The model assumes staggered price setting and shocks to domestic productivity, to the world interest rate, to world inflation and to the uncovered interest rate parity condition. Optimized policy rules have a pronounced anti-inflation stance and entail significant nominal and real exchange rate volatility. The country responds to an increase in external volatility by holding more foreign assets. The policy rule affects the variance and the mean of consumption. The effect on the mean matters significantly for welfare.