Working Paper: CEPR ID: DP4766
Authors: Martin Ellison; Lucio Sarno; Jouko Vilmunen
Abstract: We examine optimal policy in a two-country model with uncertainty and learning, where monetary policy actions affect the real economy through the real exchange rate channel. Our results show that whether policy should be cautious or activist depends on the size of one country relative to another. If one country is small relative to the other then activism is optimal. In contrast, if the two countries are equal sized then caution prevails. Caution is induced in the latter case because of the interaction between the home and foreign central banks. In a two-country symmetric equilibrium, learning is shown to be detrimental to welfare, implying that optimal policy is cautious.
Keywords: learning; monetary policy; open economy
JEL Codes: E52; E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Central banks' monetary policy decisions (activism) (E52) | Economic outcomes (inflation, output) (E31) |
| Relative size of countries (R12) | Optimality of activist monetary policy (E63) |
| Equal size of countries (R12) | Induction of caution in monetary policy (E49) |
| Central banks' actions (E58) | Potentially destabilizing future output or inflation fluctuations (E39) |
| Learning about policy effectiveness (D78) | Alteration of effectiveness of monetary policy (E52) |