Optimal Monetary Policy under Uncertainty

Optimal Monetary Policy under Uncertainty

Richard T. Froyen and Alfred V. Guender

Recently there has been a resurgence of interest in the study of optimal monetary policy under uncertainty. This book provides a thorough survey of the literature that has resulted from this renewed interest. The authors ground recent contributions on the ‘science of monetary policy’ in the literature of the 1970s, which viewed optimal monetary policy as primarily a question of the best use of information, and studies in the 1980s that gave primacy to time inconsistency problems. This broad focus leads to a better understanding of current issues such as discretion versus commitment, target versus instrument rules, and the merits of delegation of policy authority.

Chapter 11: The Forward-Looking Model: The Open Economy

Richard T. Froyen and Alfred V. Guender

Extract

This chapter presents a forward-looking model of a small open economy. The model will serve as a framework within which we examine whether there are any significant differences in the conduct of monetary policy in a small open economy compared to a closed economy. This issue has received considerable attention in the literature (Ball, 1999b; Clarida, Gali and Gertler, 2001, 2002; Svensson, 2000; Taylor, 2001; to name but a few). Our approach emphasizes that under suitable conditions the conduct of optimal monetary policy in an open economy can be very different from policymaking in a closed economy. The organization of the present chapter is in parts, similar to that of Chapter 9. After briefly describing the structural relations in the open economy framework, we compare optimal policymaking under simple commitment and discretion in the second and third sections, respectively. The delegation issue is taken up in the fourth section. In the fifth section we weigh the pros and cons of adhering to two efficient strategies of monetary policy in the open economy: hybrid nominal income targeting and strict inflation targeting. This chapter then goes on to discuss the implications of following an explicit instrument rule under inflation targeting. In the sixth section we show that, in an open economy, the determination of the optimal policy parameter in the explicit instrument rule is more complex than in the closed economy. The conditions under which an explicit instrument rule produces the same response to the...

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