Numerous rules have been proposed for the design of macroeconomic policy. Under a `monetarist rule', the government manipulates the interest rate to steer inflation towards a target path, neglecting both fiscal policy and the current account of the balance of payments. The `reversed assignment' combines this interest rate policy with fiscal control of the current account. The `Mundell assignment' uses fiscal feedback to control inflation with interest rate feedback directed to controlling the foreign balance; while a government operating a `target zone' combines this fiscal policy with an interest rate policy of completely stabilizing the real exchange rate. In Discussion Paper No. 534, Patrizio Tirelli and Research Fellow David Vines use a small open economy model incorporating wealth accumulation from the current account but not domestic wealth creation to focus on the link between current account imbalances, wealth effects and dynamic adjustment under these four policy rules. Adopting an explicit foreign wealth target under the reversed or Mundell assignments may ensure stability: in contrast, a monetarist rule can make the system inherently unstable, irrespective of the strength of policy feedback, while an exchange rate target zone must be revised whenever a shock requires permanent changes of net foreign wealth.

Tirelli and Vines then investigate the consequences of inflationary and real demand shocks under the four policy rules. For an inflationary shock under monetarism and the reversed and Mundell assignments, exchange rate swings during the transition prevent domestic output loss from permanently affecting foreign wealth, but dynamic responses to the shock differ. Under a target zone, however, such a shock has permanent effects, because controlling inflation requires a fiscal contraction, reduced domestic expenditure on imports and hence a permanent exchange rate appreciation to maintain current account equilibrium.

Under the monetarist rule, a permanent real shock to domestic demand causes uncontrolled transfers of foreign wealth requiring a major adjustment of the real exchange rate. The reversed assignment drastically reduces the total loss of foreign wealth and improves overall dynamic performance. The Mundell assignment and the target zone meet increased domestic demand with a fiscal contraction, which controls inflation and limits the foreign wealth transfer. Greater effective control of the current account is offset, however, by the negative impact of the exchange rate swings on domestic inflation. A permanent real reduction in foreign demand for domestic goods requires a long-run real devaluation, for all control rules. Again, foreign wealth transfers can only be limited by fiscal means, while the monetary targeting of foreign wealth under a target zone worsens the model's dynamic performance.
Tirelli and Vines conclude that including fiscal as well as monetary control in a policy package helps prevent instability, whether the fiscal instrument is assigned to the internal or the external objective. They note, however, that institutional lags in implementing the fiscal feedback may make this instrument suitable only for slow-moving targets, although the extent of this problem will differ across countries.

Simple Rules for the Open Economy: Evaluating Alternative Proposals
Patrizio Tirelli and David Vines

Discussion Paper No. 534, July 1991 (IM)