Policy Rules for Open Economies

This paper examines the choice of a monetary policy rule in a simple macroeconomic model. In a closed economy, the optimal policy is a ‘Taylor rule’ in which the interest rate depends on output and inflation. In an open economy, the optimal rule changes in two ways. First, the policy instrument is a ‘Monetary Conditions Index’ – a weighted average of the interest rate and the exchange rate. Second, on the right side of the rule, inflation is replaced by ‘long-run inflation’, a variable that 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.