Policy Rules and External Shocks

This article examines monetary policy rules in open economies, focusing on the need to adapt strategies to external shocks, as evidenced during the financial crises of the 1990s. The central research question is what the optimal variable and instrument should be for setting effective targets that stabilize inflation and output, given that existing models are typically based on closed economies. The analysis is conducted using a theoretical model that includes interactions among inflation, output, interest rates, and the exchange rate. Equations are used to relate these variables, and three key findings are identified that suggest the choice of instrument affects output stability depending on the type of shocks involved. Particularly, it is concluded that a Monetary Conditions Index is more effective in the face of shocks to net foreign investment, while an interest rate target is preferable in the face of shocks to exports. These implications highlight the need for greater flexibility in monetary policy approaches to respond to the dynamic nature of open economies. (Abstract and audio: Department of Economic Publications)