We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a tractable canonical system in domestic inflation and the output gap. We employ this framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with those suboptimal rules.

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In this paper, we investigate the properties of alternative monetary policy rules using four structural macroeconometric models: the Fuhrer-Moore model, Taylor’s Multi-Country Model, the MSR model of Orphanides and Wieland, and the FRB staff model. All four models incorporate the assumptions of rational expectations, short-run nominal inertia, and long-run monetary neutrality, but differ in many other respects (e.g., the dynamics of prices and real expenditures). We compute the output-inflation volatility frontier of each model for alternative specifications of the interest rate rule, subject to an upper bound on nominal interest rate volatility. Our analysis provides strong support for rules in which the first-difference of the federal funds rate responds to the current output gap and the deviation of the one-year average inflation rate from a specified target. In all four models, first-difference rules perform much better than rules of the type proposed by Taylor (1993) and Henderson and McKibbin (1993),

It is argued that inflation targeting is best understood as a commitment to a targeting rule rather than an instrument rule, eitherageneral targeting rule (explicit objectives for monetary policy) or a specific targeting rule (a criterion for (the forecasts of) the target variables to be fulfilled), essentially the equality of the marginal rates of transformation and substitution between the target variables. Targeting rules allow the use of judgment and extramodel information, are more robust and easier to verify than optimal instrument rules, and they can nevertheless bring the economy close to the socially optimal equilibrium.

Inflation targeting is a monetary-policy strategy that is characterized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast and has been called forecast targeting, and a high degree of transparency and accountability. It was introduced in New Zealand in 1990, has been very successful in terms of stabilizing both inflation and the real economy, and has, as of 2010, been adopted by about 25 industrialized and emerging-market economies. The chapter discusses the history, macroeconomic effects, theory, practice, and future of inflation targeting.

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This paper analyses the implications of imperfect exchange rate pass-through for optimal monetary policy in a linearised open-economy dynamic general equilibrium model calibrated to euro area data. Imperfect exchange rate pass through is modelled by assuming sticky import price behaviour. The degree of domestic and import price stickiness is estimated by reproducing the empirical identified impulse response of a monetary policy and exchange rate shock conditional on the response of output, net trade and the exchange rate. It is shown that a central bank that wants to minimise the resource costs of staggered price setting will aim at minimising a weighted average of domestic and import price inflation.

Schorfheide was visiting the Federal Reserve Bank of Philadelphia, for whose hospitality is thankful. Financial sup-

presented a normative analysis of monetary policy within a simple optimization-based closedeconomy framework. We derived the optimal policy rule and, among other things, characterized the gains from commitment. Also, we made precise the implications for the kind of instrument feedback rule that a central bank should follow in practice. In this paper we show how our analysis extends to the case of a small open economy. Openness complicates the problem of monetary management to the extent the central bank must take into account the impact of the exchange rate on real activity and inflation. How to factor the exchange rate into the overall design of monetary policy accordingly becomes a central consideration. Here we show that, under certain conditions, the monetary-policy design problem for the small open economy is isomorphic to the problem of the closed economy that we considered earlier. Hence, all our qualitative results for the closed economy carry over to this case. Openness does affect the parameters of the model, suggesting quantitative implications. Though the general form of the optimal interest-rate feedback rule remains the same as in the closedeconomy case, for example, how aggressively a central bank should adjust the interest rate in response to inflationary pressures depends on the degree of openness. In addition, openness gives rise to an important distinction between domestic inflation and consumer price inflation (as defined by the CPI). To the extent that there is perfect exchange-rate pass-through, we find that the central bank should target domestic

We study the design of monetary policy in a low inflation environment taking into account the limitations imposed by the zero bound on nominal interest rates. Using numerical dynamic programming methods, we compute optimal policies in a simple, calibrated openeconomy model and evaluate the e#ect of the liquidity trap generated by the zero bound. We consider the possibility that the quantity of base money may a#ect output and inflation even when the interest rate is constrained at zero and explicitly account for the substantial degree of uncertainty regarding such quantity e#ects. As an example of such a quantity e#ect, we focus on the portfolio balance channel through which changes in relative money supplies influence the exchange rate. We find that the optimal policy near price stability is asymmetric, that is, as inflation declines, policy turns expansionary sooner and more aggressively than would be optimal in the absence of the zero bound. As a consequence, the average level of inf...