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Author
L. Linnemann
A. Schabert
Year
2006
Title
Monetary Policy and the Taylor Principle in Open Economies
Journal
International Finance
Volume | Issue number
9 | 3
Pages (from-to)
343-367
Number of pages
25
Document type
Article
Faculty
Faculty of Economics and Business (FEB)
Institute
Amsterdam School of Economics Research Institute (ASE-RI)
Abstract
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.

URL
go to publisher's site
Language
English
Permalink
http://hdl.handle.net/11245/1.271293

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