Alternative Monetary Rules in the Open-economy: a Welfare-based Approach

Using an optimizing model we compare alternative monetary policy rules and exchange rate regimes for a small stochastic open economy with imperfect competition and short run price rigidity. The criteria to choose among rules and regimes are obtained using a welfare criterion derived from the utility function of the representative agent. The main findings of this paper are that, depending on what shocks affect this economy, the effects of inflation targeting on output and inflation volatility depend crucially on the exchange rate regime and the inflation index being targeted. With regard to the exchange rate, we find that the loss in agents’ welfare is much higher under managed exchange rates than under flexible rates in presence of real shocks, while for nominal shocks the reverse is true. As far as the definition of inflation targeting index is concerned, domestic inflation appears to outperform the CPI. Finally, flexible inflation targeting is welfare superior to strict targeting. ____________________ This paper is a chapter of the forthcoming book Inflation Targeting: Design, Performance, Challenges, edited by Norman Loayza and Raimundo Soto, Santiago, Chile. © 2002 Central Bank of Chile. E-mail: [email protected]. 1 ALTERNATIVE MONETARY RULES IN THE OPEN-ECONOMY: A WELFARE-BASED APPROACH Eric Parrado New York University Andrés Velasco Harvard University and the National Bureau of Economic Research How do central banks choose among alternative monetary policies? In this paper we analyze that question for an open economy following an interest rate rule. Many issues remain controversial in the design of such a rule. If inflation is targeted, as it presumably is, should the domestic interest rate also react to the output gap or to movements in other real variables? Should inflation targeting focus on the consumer price index (CPI), on home prices only, or on some other index? Should the interest rate respond to movements in the nominal exchange rate? Equivalently, should the exchange rate float cleanly? All such questions can be addressed by considering a particular social loss function and quantitatively analyzing the response of a model economy to several shocks (domestic and foreign, real and nominal) under alternative monetary rules and exchange rate regimes. The best regime is the one that stabilizes the economy and consequently yields lower social losses. That is the approach we take here. In the analysis that follows, we use a social loss function that includes the variability of the real exchange rate in addition to the variability of inflation and output, as is conventional in closed economy models. The three policy alternatives we consider and the corresponding results are as follows: —Flexible versus managed exchange rate regimes. In the former, the currency floats freely, while in the latter the central bank adjusts its domestic interest rate in response to fluctuations in the nominal Inflation Targeting: Design, Performance, Challenges, edited by Norman Loayza and Raimundo Soto, Santiago, Chile. © 2002 Central Bank of Chile. 2 E. Parrado and A. Velasco exchange rate, in addition to reacting to other variables such as inflation and output. We find that the social loss is much higher under managed exchange rates than under flexible rates in the presence of real shocks, while for nominal shocks the reverse is true. This result is consistent with conventional wisdom on the subject. —CPI versus domestic inflation targeting. In the latter, the inflation target is defined exclusively in terms of the variation of the price index for domestically produced goods. We find that domestic inflation targeting is preferable to CPI inflation targeting, since it minimizes volatility in output at the possible cost of some relatively small additional volatility in the real exchange rate. —Strict versus flexible inflation targeting. In the former, interest rate policy reacts to inflation only, while in the latter it reacts to output (and possibly the exchange rate) in addition to the target inflation rate. We find that flexible inflation targeting is generally preferable to strict inflation targeting. We carry out the analysis in a dynamic neo-Keynesian (DNK) model, modified to allow for inflation targeting in an open economy. This framework builds on previous research by Svensson (2000), Galí and Monacelli (2000), Parrado (2000), and Parrado and Velasco (2001), all of which focus on the performance of simple policy rules (whether optimal or not) in open economies. Our model contains three structural blocks: aggregate demand, aggregate supply, and a monetary sector. The aggregate demand block is derived from utility maximization. The same is true of aggregate supply, which also incorporates forward-looking sticky prices à la Calvo (1983). Studying the welfare consequences of monetary rules has only lately become fashionable among academic economists. The issue was not tackled previously for lack of tools rather than lack of interest. The most recent generation of general equilibrium sticky-price models, based on utility maximization, naturally lends itself to welfare analysis, as evidenced by the number of recent papers on the subject. Our model differs from much recent work in two dimensions. First, it focuses on a small open economy, while most pa1. Currently, some inflation targeters target the full CPI (for example, Germany, Israel, Spain, and Sweden). Others use the CPI but exclude volatile prices such as energy and food prices (for example, Australia and New Zealand). Canada, Chile, and the United Kingdom use both types of measure. 2. A partial list of recent papers incorporating an open economy, aside from works mentioned in the text, includes Benigno and Benigno (2001); Ghironi and Rebucci (2001); Monacelli (2000); Parrado (2000); Svensson (2000). 3 Alternative Monetary Rules in the Open-Economy pers—with the important exception of Galí and Monacelli (2000)— focus on a world economy composed of two countries of comparable size. As Lane (2001) points out, much of the literature has been based on a two-country world, since this allows interest rates and asset prices to be endogenously determined. However, this benefit comes at the price of considerable model complexity and may not be of compelling importance for the analysis of issues relevant to a small open economy. Second, we focus on interest rate policies, while most other papers try to characterize the optimal behavior of the nominal quantity of money, starting with the seminal paper of Obstfeld and Rogoff (1995). The paper is organized as follows. Section 1 outlines the model. Section 2 presents the solution of the model and its parameterization, while section 3 analyzes alternative policy experiments. Section 4 summarizes the results and their implications for models of monetary policy and discusses caveats and directions for future research. 1. A STICKY-PRICE MODEL The model consists of an open economy that comprises a central bank, a fiscal authority (the government), a representative consumer, and monopolistically competitive firms. All goods are tradable. As is standard in the literature, domestic production requires a continuum of differentiated labor inputs that are supplied by home individuals. Time is discrete. We proceed in three steps. First, we outline the main building blocks of the model and its microeconomic foundations. Second, we derive the main price relationship of the model, namely, inflation rates and exchange rates. Finally, we embed these relationships in an otherwise conventional DNK model. 1.1 Microeconomic Foundations of Demand and Supply The economy has a continuum of measure 1 of consumer-producers indexed by j ∈ (0,1). Each consumer-producer has the same intertemporal lifetime utility function,