11. The forward-looking model: the open economy 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...
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