Working Paper: NBER ID: w20545
Authors: Richard Clarida
Abstract: This paper reviews and interprets some of the key policy implications that flow from a class of DSGE models for optimal monetary policy in the open economy. The framework suggests that good macroeconomic outcomes in open economies are possible by focusing inflation targeting that is implemented by a Taylor type rule, a rule that in equilibrium is reflected in the exchange rate as an asset price. Optimal monetary policy will not be able deliver a stationary ('stable') nominal exchange rate - let alone a fixed exchange rate or one that remains inside a target zone ‐ because, absent a commitment device, optimal monetary can't deliver a stationary domestic price level. Another feature in the data for inflation targeting countries that is consistent with monetary policy via Taylor type rule is that it will tend push the nominal exchange rate in the opposite direction from PPP in response to an 'inflation' shock - the 'bad news god news' result of Clarida -Waldman (2008;2014). This is so even though in the long run of these models the nominal exchange rate must in expectation obey PPP.
Keywords: Monetary Policy; Open Economies; Inflation Targeting; Taylor Rule
JEL Codes: E52; E58; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal monetary policy (E63) | desirable macroeconomic outcomes (E60) |
| absence of a commitment device (D10) | inability to stabilize exchange rates (F31) |
| inflation shocks (E31) | movement in nominal exchange rate (F31) |
| inflation announcements (E31) | exchange rate expectations (F31) |
| policy response to inflation (E64) | exchange rate dynamics (F31) |