On Optimal Monetary Policy Rules and the Role of MCIs in the Open Economy
Abstract: This paper has two focal points. First, it presents a simple open macro model to underscore the important effect of the real exchange rate on the rate of inflation in the Phillips curve. The existence of the direct exchange rate effect on inflation has material consequences for the conduct of optimal monetary policy in the forward-looking open economy framework. As opposed to the closed economy framework optimal monetary policy in the open economy depends on both demand-side and supply-side parameters. In addition, it is shown that the temporal properties of the disturbances that impinge upon the economy affect the setting of the optimal policy parameter in the monetary policy rule. Second, this paper points out the limitations of relying on conventional MCIs as indicator variables or operating targets in the conduct of monetary policy. The conventional MCIs that are used by central banks, international organizations, and consulting companies feature a weight on the real exchange rate that is composed of two demand-side elasticities. The model employed in this paper gives rise to an alternative MCI where the weight on the real exchange rate depends on all parameters of the model and the policymaker's preference parameter.
JEL Code: E5, F4
Keywords: open economy, direct exchange rate channel, optimal monetary policy,
MCI.