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Monetary policy and uncertainty in an empirical small open‐economy model
Author(s) -
Justiniano Alejandro,
Preston Bruce
Publication year - 2010
Publication title -
journal of applied econometrics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.878
H-Index - 99
eISSN - 1099-1255
pISSN - 0883-7252
DOI - 10.1002/jae.1153
Subject(s) - economics , small open economy , currency , exchange rate , inflation (cosmology) , open economy , monetary policy , econometrics , class (philosophy) , price setting , interest rate , contrast (vision) , macroeconomics , monetary economics , microeconomics , computer science , physics , artificial intelligence , theoretical physics
This paper explores optimal policy design in an estimated model of three small open economies: Australia, Canada and New Zealand. Within a class of generalized Taylor rules, we show that to stabilize a weighted objective of output consumer price inflation and nominal interest variation optimal policy does not respond to the nominal exchange. This is despite the presence of local currency pricing and due, in large part, to observed exchange rate disconnect in these economies. Optimal policies that account for the uncertainty of model estimates, as captured by the parameters' posterior distribution, similarly exhibit a lack of exchange rate response. In contrast to Brainard (1967), the presence of parameter uncertainty can lead to more or less aggressive policy responses, depending on the model at hand. Copyright © 2010 John Wiley & Sons, Ltd.