Taylor rules in the open economy

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.euroecorev.2009.04.009 Byline: Campbell Leith (a), Simon Wren-Lewis (b) Keywords: Taylor rules; Inflation targeting; Interest rate rules Abstract: Taylor rules, which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. Their determinacy properties have also been analysed in the context of closed and, to a more limited degree, in small open economy models. In this paper, we extend the analysis of the determinacy properties of Taylor rules to the case of a benchmark two-country model. When the rules are specified in terms of output-price inflation we confirm and extend the conventional results from the closed economy literature -- satisfying the Taylor principle is the key to ensuring determinacy, although the presence of backward-looking price-setting can affect the determinacy properties of the two-country model. However, the conventional results do not hold when we replace output-price inflation with consumer price inflation in the specification of the rule. In this case, Taylor rules which satisfy the Taylor principle will be indeterminate, unless there is an unusually large home bias in consumption. Similar indeterminacy problems arise when one country targets CPI inflation and the other output-price inflation. In this case we show that, even if determinacy is achieved, large spillovers may occur between countries. Author Affiliation: (a) Department of Economics, University of Glasgow, Adam Smith Building, Glasgow G12 8RT, UK (b) Department of Economics, University of Oxford, Manor Road Building, Manor Road, Oxford, OX1 3UQ, UK Article History: Received 13 March 2006; Accepted 24 April 2009 Article Note: (footnote) [star] Financial support from the ESRC (Grant nos. L138251050 and RES-156-25-003) is gratefully acknowledged. We would like to thank the editor, Juergen von Hagen, two anonymous referees, Tanya Kirsanova, Alan Sutherland and participants at conferences at the Universities of Oxford and Warwick for helpful comments on an earlier draft of the paper.