Simple Monetary Policy Rules in an Open-Economy, Limited-Participation Model

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The authors assess the stabilization properties of simple monetary policy rules within the context of a small open-economy model constructed around the limited-participation assumption and calibrated to salient features of the Canadian economy. By relying on limited participation as the main nominal friction that affects the artificial economy, the authors provide an important check of the robustness of the results obtained using alternative environments in the literature on monetary policy rules, most notably the now-standard "New Keynesian" paradigm that emphasizes rigidities in the price-setting mechanism.

The authors' analysis identifies general principles to which a rule should adhere to possess favourable stabilization properties. The rule should direct monetary authorities to increase nominal interest rates significantly when lagged interest rates are already high. By contrast, upward pressures on output (and perhaps also on inflation) should lead to decreases in interest rates. Further, monetary policy should be essentially unconcerned with exchange rate movements. In addition, responding to future inflation, rather than the current rate, does not generate significant welfare improvements.

While some of these principles are similar to those obtained using alternative environments, the recommendation that monetary policy should lower rates when output or inflation is pushing upward is more specific to limited-participation models. This recommendation is linked to the fact that, in such models, expected rises in inflation lead the financial system to contract aggregate loanable funds and push economic activity downward, thus embedding a negative correlation between inflationary and output pressures in the model economy. In that sense, the authors' analysis might be interpreted as the study of an economy in which financial markets have limited flexibility to react to shocks and how this limited flexibility impinges on the choice of a "good" monetary policy rule.