Working Paper: NBER ID: w2018
Authors: Peter J. Stemp; Stephen J. Turnovsky
Abstract: This paper analyzes the optimal intertemporal tradeoff between inflation and output in an open economy under perfect foresight. The announcement of the optimal plan may, or may not, generate an initial jump in the exchange rate. That depends upon the real adjustment costs, which such unanticipated changes impose on the economy. In the case that such jumps occur, the question of time consistency of the optimal policy arises. A time consistent solution is obtained provided: (i) the policy maker is not too myopic; (ii) the adjustment costs associated with the jump in the exchange rate are of an appropriate form. The optimal monetary rule is derived and properties of this rule, as well as the overall optimal adjustment of the economy are discussed.
Keywords: monetary policy; open economy; inflation; output; exchange rate
JEL Codes: E52; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| announcement of an optimal monetary plan (E60) | initial jump in the exchange rate (F31) |
| real adjustment costs (F16) | extent of the exchange rate jump (F31) |
| myopia of the policy maker (D78) | stability of the economic outcomes (P27) |
| monetary supply adjustments (E51) | inflation (E31) |
| monetary supply adjustments (E51) | output (C67) |
| initial monetary expansion (E19) | increased output (E23) |
| initial monetary expansion (E19) | increased inflation (E31) |
| optimal monetary rule (E52) | adjusting the real money supply in response to changes in the real exchange rate (F31) |