Interest Rate Feedback Rules in an Open Economy with Forward Looking Inflation.

With the adoption of an explicit inflation target in the UK, there has been renewed interest in the properties of alternative interest rate feedback rules. Following Svensson (1999), a literature examining the relative merits of inflation and price level targeting has also developed. In this paper, we compare the stabilization properties of the two forms of feedback rule that have been used most frequently in the literature and that give rise to price level and inflation targeting, respectively. The model in which we embed our rules is significantly richer than those considered in the price level targeting literature and this allows us to explain why the relative performance of the rules is dependent upon the nature of the shock considered and whether or not excess inflation is defined in terms of consumer or output price inflation. Copyright 2001 by Blackwell Publishing Ltd