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Taylor Rules in the Open Economy

Author

Listed:
  • Campbell Leith

    (University of Glasgow)

  • Simon Wren-Lewis

    (Department of Economics, University of Exeter)

Abstract
Taylor rules which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. A key question that arises when analysing the conduct of such policy rules in the open economy case is whether the relevant measure of inflation is the growth in output prices or consumer prices. In this paper, we show that embedding a rule specified in terms of output price inflation into a benchmark two-country model confirms the existing result that local stability requires that the response of nominal interest rates to excess inflation should be such that real interest rates rise (the Taylor Principle), but this requirement may be partially offset by raising the interest rate response to increases in the output gap. However, all the conventional results do not hold when we replace output price inflation with consumer price inflation. In this case, Taylor rules which satisfy the Taylor principle will not support a unique rational expectations path for prices and other macroeconomic variables in response to specific shocks. Our results suggest that adoption of consumer price based Taylor rules might be chronically destabilising.

Suggested Citation

  • Campbell Leith & Simon Wren-Lewis, 2002. "Taylor Rules in the Open Economy," Discussion Papers 0203, University of Exeter, Department of Economics.
    • Handle: RePEc:exe:wpaper:0203
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

    Citations

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    Cited by:

    1. Stephen McKnight & Alexander Mihailov, 2015. "Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies?," Economica, London School of Economics and Political Science, vol. 82(328), pages 938-975, October.
    2. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Oxford Economic Papers, Oxford University Press, vol. 63(4), pages 673-699, December.
    3. Luis-Felipe Zanna & Mr. Marco Airaudo, 2012. "Interest Rate Rules, Endogenous Cycles, and Chaotic Dynamics in Open Economies," IMF Working Papers 2012/121, International Monetary Fund.
    4. Airaudo, Marco & Zanna, Luis-Felipe, 2012. "Interest rate rules, endogenous cycles, and chaotic dynamics in open economies," Journal of Economic Dynamics and Control, Elsevier, vol. 36(10), pages 1566-1584.
    5. Wolfram Berger, 2010. "International Policy Coordination and Simple Monetary Policy Rules," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 146(II), pages 451-479, June.
    6. Leith, Campbell & Wren-Lewis, Simon, 2008. "Interactions between monetary and fiscal policy under flexible exchange rates," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2854-2882, September.
    7. Fujisaki, Seiya, 2012. "Interest Rate Control Rules and Macroeconomic Stability in a Heterogeneous Two-Country Model," MPRA Paper 37017, University Library of Munich, Germany.
    8. repec:zbw:bofitp:2018_006 is not listed on IDEAS
    9. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages 208-231, June.
    10. Ludger Linnemann & Andreas Schabert, 2006. "Monetary Policy and the Taylor Principle in Open Economies," International Finance, Wiley Blackwell, vol. 9(3), pages 343-367, December.
    11. Zhang, Chengsi & Dang, Chao, 2018. "Is Chinese monetary policy forward-looking?," BOFIT Discussion Papers 6/2018, Bank of Finland, Institute for Economies in Transition.
    12. Teresa Sousa, 2011. "International macroeconomic interdependence and imports of oil in a small open economy," Portuguese Economic Journal, Springer;Instituto Superior de Economia e Gestao, vol. 10(1), pages 35-60, April.
    13. Gießler, Stefan, 2020. "The evolution of monetary policy in Latin American economies: Responsiveness to inflation under different degrees of credibility," IWH Discussion Papers 9/2020, Halle Institute for Economic Research (IWH).

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    More about this item

    Keywords

    Taylor Rules; Inflation Targeting; Interest Rate Rules.;
    All these keywords.

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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