Schorfheide was visiting the Federal Reserve Bank of Philadelphia, for whose hospitality is thankful. Financial sup-

Skeptic views on EMU are usually cast around three arguments. First, the single European currency will be harmful unless the EU satisfies Optimum Currency Area (OCA) conditions, and this is not likely to be the case except for a small number of core countries. Second, heterogeneous economic and financial structures will create undesired differences in the local impact of the single monetary policy. Third, the shift from domestic to area-wide considerations may give rise to conflicts in the decision making process of the European Central Bank (ECB).

What is a good monetary policy rule for stabilizing the economy? In this paper, efficient policy rules are computed using the FRB/US large-scale openeconomy macroeconometric model. Simple three-parameter policy rules are found to be very effective at minimizing fluctuations in inflation, output, and interest rates: Increases in rule complexity yield only trivial reductions in aggregate variability. Under rational expectations, efficient policies smooth the interest rate response to shocks and use the feedback from anticipated policy actions to stabilize inflation and output and to moderate movements in shortterm interest rates. Policy should react to a multi-period inflation rate rather than the current quarter inflation rate; in fact, targeting the price level, as opposed to the inflation rate, involves only small additional stabilization costs. These results are robust to parameter and model uncertainty and the imposition of the non-negativity constraint on nominal intere...

The central bank’s optimal reaction to foreign and domestic shocks is analyzed in an inflation targeting model allowing for incomplete exchange rate pass-through. Limited pass-through is incorporated through nominal rigidities in an aggregate supply-aggregate demand model derived from some microfoundations. Three main results are obtained. First, the results suggest that the interest rate response to foreign shocks is smaller when pass-through is low. Second, the inflation-output variability trade-off becomes more favourable as pass-through decreases. Third, lower pass-through, that is larger nominal rigidity, leads to higher exchange rate volatility. With exogenous nominal price stickiness, part of the required relative price adjustment is provided through larger movements in the endogenously determined exchange rate.

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In this paper, the interaction between inflation and monetary policy rules is analysed within the framework of a dynamic general equilibrium model derived from optimising behaviour and rational expectations. Using model simulations, it is illustrated that the control of monetary policy over the inflation process is strongly dependent on the role of forward looking expectations in the price and wage setting process and on the credibility of monetary policy in the expectation formation process of the private sector. Furthermore, the central bank should take into account a wide variety of indicators in making monetary policy decisions in order to approach the optimal monetary policy rule as closely as possible. 2 NBB WORKING PAPER No.1 - MARCH 2000 NBB WORKING PAPER No.1 - MARCH 2000 3 TABLE OF CONTENTS: 1. INTRODUCTION .............................................................................................................................1 2. A DYNAMIC GENERAL EQUILIBRIUM MODEL ...

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The use of explicit inflation targets has meant that monetary policy has become more transparent and also easier to evaluate. The analysis in this paper is based on forecasts by Sveriges Riksbank (the central bank of Sweden) on real output and inflation. Our purpose is to separate the effects on the interest-rate instrument from (i) discretionary changes in the rule for monetary policy, and (ii) judgements in forecasting. We first feed the Riksbank’s forecasts into two different simple rules for interest-rate policy. The differences between the interest rates implied by these benchmark rules and the actual policy rate are interpreted as measures of “policy shocks”. Second, we compare the Riksbank’s forecasts with alternative forecasts. Using a benchmark rule for the setting of the policy rate, we can use the differences between the forecasts to define measures of the effects of the Riksbank’s “judgements ” on its interestrate policy.

One distinguishable characteristic of emerging economies is that they are not financially robust. These economies are incapable to smooth out large external shocks as sudden capital outflows or terms of trade shocks imply large and abrupt swings in the real exchange rate. This could be very costly if the real exchange rate swings trigger a financial crisis as in the case of highly un-hedged liability dollarized economies. Using a small open economy model this paper examines alternative monetary policy rules for economies with different degrees of liability dollarization. The paper aims to answer the question of how efficient is to use inflation targeting when the liability dollarization ratio is high. Our findings suggest that it might be optimal to follow a non-linear policy rule that defends the real exchange rate in a financially vulnerable economy.

We explore the link between an interest rate rule for monetary policy and the behavior of the real exchange rate. The interest rate rule, in conjunction with some standard assumptions, implies that the deviation of the real exchange rate from its steady state depends on the present value of inflation and output gap differentials. An initial look at German data yields some support for the model. We thank the National Science Foundation for financial support, Jeffrey Frankel, Roberto Perotti, Hélène Rey, three anonymous referees and participants in the June 2002 ISOM conference for helpful