Optimal Monetary Policy under Uncertainty
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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.
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Chapter 5: Optimal Monetary and Exchange Rate Policy in the Open Economy

Richard T. Froyen and Alfred V. Guender


The models considered so far have been of closed economies. This has been a convenient simplification in considering a number of issues. Real economies are open and international trade and capital flows are important. In this chapter we extend our previous analysis to an open-economy context. New questions raised by openness are also addressed. We consider two types of models differentiated by degree of capital mobility: perfect versus imperfect. After a brief treatment of the fixed-price model of the type in Chapters 2 and 3, the focus is on open-economy versions of the type of model in Chapter 4, including variable wages and prices, rational expectations and supply shocks. Several patterns emerge. The first is the interdependence of the choice of a monetary policy target and the optimal exchange rate regime. The so-called “unholy trinity” of an independent monetary policy, fixed exchange rate and high degree of capital mobility is an example of this interdependence but the connections are ubiquitous. Second, a Poole-type ranking of monetary policies where an interest rate target is preferred when financial market shocks are predominant whereas a money supply target is preferred when demand-side shocks to the goods market (IS shocks) are predominant is quite robust to introducing openness to the models. Finally, aggregate supply shocks continue to raise difficult conflicts for optimal policy and exchange rate movements are an additional source of supply disturbances. THE MUNDELL–FLEMING MODEL Mundell (1963) and Fleming (1962) developed an open-economy version of the IS...

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