National Taiwan University
March 11, 2008
Abstract:
We develop a New Keynesian small open economy model to compare the welfare perfor-mances of two classes of monetary policy rules: exchange rate rules and interest rate rules.
The expected lifetime utility of the representative household is used as the welfare criterion.
The model is solved using second-order approximation methods. We …nd that under bench-mark parameterization, an exchange rate rule delivers lower standard deviations of GDP and in‡ation compared to an interest rate rule, when the economy has a high degree of openness.
However, despite that, an exchange rate rule is welfare inferior to an interest rate rule since it delivers lower mean terms of trade, which leads to lower mean consumption and higher mean labor hours. On the other hand, when the elasticity of substitution for export is high, an exchange rate rule is welfare superior to an interest rate rule, regardless of the degree of openness, as the di¤erences in mean terms of trade for the two classes of rules become smaller.
Keywords: Exchange rate rules, interest rate rules, monetary policy, welfare comparison, small open economy
JEL Classi…cation: E52, F41
This paper has been previously circulated under the title: Revisiting Exchange Rate Rule. I would like to thank participants at the 2007 Society of Computational Economics Annual conference for useful discussions. Financial support from the National Science Council of Taiwan, grant NSC 95-2415-H-002-020 is gratefully acknowledged.
yDepartment of Economics, National Taiwan University, 21 Hsu Chow Road, Taipei 100, Taiwan. Phone:
(886) 2351-9641-ext 449, Fax: (886) 2351-1826, Email: wlteo@ntu.edu.tw.
1 Introduction
Ever since the seminal contribution of Taylor (1993), monetary policy discussions have been dominated by "interest rate rules", a class of monetary policy rules where interest rates react endogenously to a small set of macroeconomic variables. An important reason for the success of the Taylor-style interest rate rules is that Taylor (1993) and many subsequent contributions have demonstrated that this class of rules seems to describe the actual monetary policies of many central banks in advanced countries rather well.1 Another reason for their popularity is that they are simple, easy to understand and implement. As a result, many studies have been devoted to study both the positive and normative implications of interest rate rules.
Despite the popularity of interest rate rules, there are some alternative monetary policy rules that might be worth studying.2 One such alternative is "exchange rate rules", de…ned here to be a class of monetary policy rules where nominal exchange rates react endogenously to a small set of macroeconomic variables. One reason why exchange rate rules deserve some attention is that Parrado (2004) and McCallum (2006, 2007) have shown that this class of rules describes Singapore’s monetary policy rather well. The Monetary Authority of Singapore also states that "[i]n Singapore, monetary policy is centered on the management of the exchange rate, rather than money supply or interest rates." (Monetary Authority of Singapore, 2001). Even though Singapore is a very small country, McCallum (2007) argues aptly that its monetary policy deserves attention because Singapore has more population and a larger GDP in dollar term than New Zealand, which is a pioneer in "world-wide surge toward in‡ation targeting". Parrado (2004) also observes that Singapore’s monetary
1See for example, Clarida et al. (1998, 2000), Lubik and Schorfheide (2004, 2007).
2In addition to the exchange rate rules discussed in this paper, base money rules (e.g. McCallum, 1988) and MCI rules (e.g. Ball, 1999) have also been explored in the literature.
policy "has helped achieve a track record of low in‡ation with prolonged economic growth".
Moreover, using a dynamic stochastic general equilibrium (DSGE) model, McCallum (2006, 2007) shows that for a very open economy like Singapore, an exchange rate rule can deliver a much lower volatility of output gap, compared to an interest rate rule, with only slightly higher volatility of in‡ation.
The goal of this paper is to compare the welfare implications of exchange rate rules and interest rate rules. Like McCallum (2006, 2007), we construct a New Keynesian small open economy DSGE model for the analysis. In contrast to McCallum (2006, 2007), we will use the expected lifetime utility of the representative household as the welfare criterion, following most of the recent literature. This distinction is important, since the literature has found that monetary policy can have important implications for the representative household’s utility beyond the traditional focus on the volatility of in‡ation and output gap, especially in open economy context.3 By using the expected lifetime utility of the representative household as the welfare criterion, we are able to incorporate e¤ect such as the mean terms of trade, which is not explored in McCallum (2006, 2007), but turns out to be important for the representative household’s utility.
Like McCallum (2006, 2007), our results suggest that an exchange rate rule can deliver a lower standard deviation of output, compared to an interest rate rule, when the economy is a very open economy. In addition, unlike McCallum (2006, 2007), we also …nd that an exchange rate rule can deliver a lower standard deviation of in‡ation in our model, when the degree of openness is high. The intuition for the results above is as follow. An exchange rate rule tends to lead to a lower volatility of nominal exchange rate, compared to an interest rate rule. The lower volatility of nominal exchange rate leads to a less volatile imported goods price in‡ation, which can be thought of as more stable supply shocks, since imported goods are inputs in the production process in our model. This e¤ect dominates when the degree
3See for instance, Bacchetta and van Wincoop (2000), Bergin et al. (2007) and Sutherland (2006).
of openness is high, so that imported goods as a share of gross output is high. The lower volatility of in‡ation also means that an exchange rate rule leads to a lower mean resource cost of price dispersion.
Despite the lower mean resource cost of price dispersion, we …nd that an exchange rate rule is welfare inferior to an interest rate rule under the benchmark parameterization, re-gardless of the degree of openness. The result hinges on the e¤ects of the mean terms of trade. Since an interest rate rule delivers a higher standard deviation of nominal exchange rate, it also leads to a more favorable average terms of trade as exporters set a higher price to cushion for nominal exchange rate uncertainty. The more favorable terms of trade leads to a higher mean consumption and lower mean labor hours for an interest rate rule, and hence higher welfare compared to an exchange rate rule.
In spite of the results above, we …nd that an exchange rate rule can be welfare superior to an interest rate rule for alternative parameterization of the model. Speci…cally, when the elasticity of substitution for export is high but within the range for empirical estimates, an exchange rate rule can beat an interest rate rule regardless of the degree of openness.
This is because when the elasticity of substitution for export is high, exchange rate rules and interest rate rules di¤er less in terms of the average level of terms of trade, leaving the welfare di¤erence to be dominated by the mean resource cost of price dispersion.
The rest of the paper is organized as follow. We present the model in Section 2. The welfare measure is discussed in Section 3. Section 4 discusses the calibration and solution methods. The results are presented in Section 5. Section 6 concludes.