Research Discussion Papers, Bank of Finland
No 6/2007:
Robust Taylor rules in an open economy with heterogeneous expectations and least squares learning
Mikael Bask ()
and Carina Selander
Abstract: The aim of this paper is threefold: (i) to investigate if
there is a unique rational expectations equilibrium (REE) in the small open
economy in Galí and Monacelli (2005) that is augmented with technical
trading in the foreign exchange market; (ii) to investigate if the unique
REE is adaptively learnable in a recursive least squares sense; and (iii)
to investigate if the unique and adaptively learnable REE is desirable in
an inflation rate targeting regime in the sense that a low and not too
variable CPI inflation rate in equilibrium is achieved. The monetary
authority is using a Taylor rule when setting the nominal interest rate,
and we investigate numerically the properties of the model developed. A
main conclusion is that the monetary authority should increase (decrease)
the interest rate when the CPI inflation rate increases (decreases) and
when the currency gets stronger (weaker) to have a desirable rule that is
robust with respect to the degree of technical trading in the foreign
exchange market. Thus, the value of the currency is a better response
variable than the output gap in the most desirable parametrizations of the
interest rate rule.
Keywords: determinacy; foreign exchange; inflation rate targeting regime; interest rate rule; robust monetary policy; technical trading; (follow links to similar papers)
JEL-Codes: E52; F31; (follow links to similar papers)
54 pages, May 9, 2007
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