Working Paper: CEPR ID: DP78
Authors: Rod Whittaker; Simon Wren-Lewis; Keith Blackburn; David Currie
Abstract: The potential instability of a fixed monetary rule combined with automatic fixed stabilisers is a well-established feature of closed economy IS/LM models with wealth effects and asset accumulation. This paper examines the stability issue in a general open economy macromodel with alternative expectations mechanisms (rational or adaptive) in both the labour market and the foreign exchange market. The fixed monetary rule is found to be stabilising only in special cases, notably when post-tax real interest rates are negative and the foreign exchange market is characterised by high capital mobility and rational expectations. By contrast, the alternative rule of fixing the rate of growth of nominal government debt is stable for a wide range of parameter values and alternative expectations schemes.
Keywords: monetary policy; open economy; macro; rational expectations; adaptive expectations
JEL Codes: 321
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fixed monetary rule (E42) | instability (C62) |
| negative posttax real interest rates + high capital mobility + rational expectations (F21) | fixed monetary rule stability (E60) |
| bondist policy rule (D72) | stability (C62) |
| combination of monetary targeting and automatic fiscal stabilizers (E63) | instability (C62) |
| bondist policy rule + fixed stabilizers (E63) | stability (C62) |
| expectations formation process (adaptive vs rational) (D84) | dynamics of adjustment process (F32) |