Policy Rules and External Shocks

Abstract

This essay discusses rules for monetary policy in open economies. If policymakers seek to stabilize output and inflation, optimal rules in open economies differ considerably from optimal rules in closed economies. In open economies, stability is best achieved by targeting long-run inflation, a measure of inflation adjusted to remove transitory effects of exchange-rate movements. Stability is also enhanced by adding an exchange-rate term to "Taylor rules" for setting interest rates. Finally, central banks must choose whether their policy instrument is an interest rate or a "monetary conditions index": an average of the interest rate and the exchange rate. The nature of shocks to the exchange rate determines which of these choices keeps output and inflation more stable.