The Role of the Exchange Rate in Monetary-Policy Rules

For a country that chooses not to "permanently" fix its exchange rate through a currency board, or a common currency, or some kind of dollarization, the only alternative monetary policy that can work well in the long run is one based on the trinity of (i) a flexible exchange rate, (ii) an inflation target, and (iii) a monetary policy rule.' While not often put into this threepart format, the desirability of such a monetary policy in an open economy is, in my view, the clear implication of three corresponding strands of recent monetary research: (i) research on fixed-exchange-rates regimes, including the influential 1995 article "The Mirage of Fixed Exchange Rates" by Maurice Obstfeld and Kenneth Rogoff and the many analyses of the breakdown of fixed-exchange-rate regimes in the late 1990's; (ii) research on the practical success with inflation targeting by Ben Bernanke et al. (1999); and (iii) research on the benefits of simple monetary-policy rules (see e.g., Taylor, 1999a). This clear policy implication, however, does not end the debate about how exchange rates should be taken into account in formulating monetary policy. Even if one excludes capital controls and sterilized exchange-market intervention from consideration because they are not effective or attractive ways to de-link exchangerate movements from the domestic interest rate, a crucial question remains: "How should the instruments of monetary policy (the interest rate or a monetary aggregate) react to the exchange rate? Should policymakers avoid any reaction and focus instead on domestic indicators such as inflation and real GDP? Or is "the rule of thumb" that "a substantial appreciation of the real exchange rate . .. furnishes a prima facie case for relaxing monetary policy," as characterized by Obstfeld and Rogoff (1995, p. 93), a better monetary policy rule? Or perhaps policymakers should heed the Obstfeld-Rogoff warning that "substantial departures from PPP [purchasing-power parity], in the short run and even over decades" make such a policy reaction to the exchange rate undesirable. More generally, if one accepts the trinity concept of monetary policy in an open economy, then what is the role of the exchange rate in the monetarypolicy rule?