Interest Rate Rules and Welfare in Open Economies

Abstract

This paper analyses the welfare performance of a set of five alternative interest rate rules in an open economy stochastic dynamic general equilibrium model with nominal rigidities. A rule with a lagged interest rate term, high feedback on inflation and low feedback on output is found to yield the highest welfare for a small open economy. This result is robust across different degrees of openness, different sources of home and foreign shocks, alternative foreign monetary rules and different specifications for price setting behaviour. The same rule emerges as both the Nash and cooperative equilibria in a two-country version of the model.Welfare, Monetary Policy, Interest Rate Rules, Second Order Approximation.