Working Paper: CEPR ID: DP3279
Authors: Robert Kollmann
Abstract: 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.
Keywords: business cycles; interest rate rules; open economy
JEL Codes: E40; F30; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimized Taylor-style interest rate rules (E43) | significant volatility in both nominal and real exchange rates (F31) |
| optimized Taylor-style interest rate rules (E43) | variance and mean of consumption (D11) |
| variance and mean of consumption (D11) | welfare (I38) |
| increase in external volatility (F31) | hold more foreign assets (G15) |
| hold more foreign assets (G15) | consumption means and variances (E20) |
| UIP shocks (J65) | welfare (I38) |
| UIP shocks (J65) | higher average stock of foreign bonds (G15) |
| productivity shocks (O49) | output fluctuations (E39) |
| UIP shocks (J65) | exchange rate fluctuations (F31) |
| monetary policy (E52) | welfare (I38) |