Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 2002:8: Should Exchange Rates be Ignored in the Setting of Monetary Policy?

Dan Nyberg ()
Additional contact information
Dan Nyberg: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden

Abstract: The aim of this paper is to highlight the role of parameter uncertainty in optimal open-economy monetary policy. Parameter uncertainty is introduced by assuming that the coefficients of the model are random, but with known stochastic properties. The results indicate that the Taylor rule is a reasonable approximation to optimal monetary policy under uncertainty, even in an open economy. The intuition behind the result is the "Brainard conservatism principle", which drives the respone coefficients of the exchange rate variables in the optimal rule close to zero, while the response coefficients on inflation and output are similar to values suggested by Taylor. The model is estimated on German data and the Taylor rule is found to be roughly similar to the optimal rule under uncertainty.

Keywords: Model uncertainty; open-economy inflation targeting; Taylor rules

JEL-codes: E52; E58; F41

32 pages, April 15, 2002

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