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Monetary Policy and the Taylor Principle in Open Economies
Author(s) -
Linnemann Ludger,
Schabert Andreas
Publication year - 2006
Publication title -
international finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.458
H-Index - 39
eISSN - 1468-2362
pISSN - 1367-0271
DOI - 10.1111/j.1468-2362.2006.00189.x
Subject(s) - economics , monetary policy , interest rate , inflation targeting , inflation (cosmology) , monetary economics , real interest rate , taylor rule , fisher hypothesis , exchange rate , nominal interest rate , depreciation (economics) , currency , macroeconomics , international fisher effect , central bank , open economy , keynesian economics , market economy , physics , capital formation , financial capital , theoretical physics , human capital
Nowadays, central banks mostly conduct monetary policy by setting nominal interest rates. A widely held view is that central banks can stabilize inflation if they follow the Taylor principle, which requires raising the nominal interest rate more than one‐for‐one in response to higher inflation. Is this also correct in an economy open to international trade? Exchange rate changes triggered by interest rate policy might interfere with inflation stabilization if they alter import prices. The paper shows that this destabilizing effect can prevail if (a) the central bank uses consumer (rather than producer) prices as its inflation indicator or directly reacts to currency depreciation, and (b) if it bases interest rate decisions on expected future inflation. Thus, if the central bank looks at current inflation rates and ignores exchange rate changes, Taylor‐style interest rate setting policies are advisable in open economies as well.