Reflections on Monetary Policy in the Open Economy

The purpose of this paper is to provide some intuition and quantitative insight into monetary policy choices faced in the open economy. The approach we pursue in the theoretical sections of the paper is to “inspect the mechanism” of the two-country Clarida, Gali, and Gertler (2002) optimizing model by focusing on the three main building blocks that can be derived from it: the “open-economy” IS curve, the open-economy Phillips curve, and the open-economy Taylor rule. We emphasize the following results that are based on a benchmark specification of the model, which assume that the elasticity of substitution in consumption is less than one.
First, there will in general be a spillover from foreign output to potential domestic output: potential output in the open economy is not a closed-economy construct and cannot be defined without reference to global developments. Second, there will in general be a spillover from foreign output growth to the domestic neutral real interest rate; again the “domestic” neutral real interest rate cannot be defined without reference to global developments. Third, we show that a more open economy may be expected to have a flatter Phillips curve, a subject that has recently received considerable empirical attention. We show that under optimal monetary policy in this model, a more open economy places a larger weight on inflation stabilization in the appropriately derived quadratic approximation to the social welfare function and that optimal monetary policy in the open economy can be written as a Taylor rule in the neutral real interest rate and expected domestic inflation. However, while a Taylor rule is one way to write the optimal policy rule, the optimal policy rule can also be written as an augmented Taylor rule that includes the rate of nominal exchange rate depreciation and the home-foreign growth differential. Finally, we review a novel empirical implication of a version of this model, one that is supported in the data, that bad news about inflation will be good news for the exchange rate under a version of inflation targeting, notwithstanding an assumption that purchasing power parity holds in the long run.
The paper also introduces a new way to calibrate forward-looking central bank policy rules using financial market data on real interest rates on inflation-indexed bonds and break-even inflation rates as an alternative to the instrumental variable, generalized method of moments approach introduced in Clarida, Gali, and Gertler (1998). We apply this approach to the Fed and European Central Bank reaction functions since 2000 and find that it accounts well for policy with much less emphasis on interest rate smoothing than in prior work. According to this analysis, variations in the neutral real interest rate, perhaps due to the “global saving glut” and enhanced financial integration in a world of inflation-targeting central banks, have played an important role in Fed policy this decade. For the ECB, the results are less clear-cut owing to the limited issuance of inflation-indexed bonds during much of the sample but are nonetheless encouraging.