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This paper investigates the applicability of open-economy convergence-consistent instrument rules for monetary policies in the economies undergoing monetary convergence to a common currency area. The proposed policy rule is forward-looking, consistent with a monetary framework based on inflation-targeting containing input variables that are relative to the corresponding variables in the common currency area. Robust forms of the policy rule are tested empirically for three inflation-targeting countries converging to the euro, i.e. the Czech Republic, Poland and Hungary. Empirical tests imply systemic differences in monetary policies among these euro-candidates. The Czech monetary policy seemingly follows the rule prescribed by our model. Both the Czech and the Polish central bank interest rate policies respond predominantly to changes in the inflation gap, while the Hungarian responds mainly to the exchange rate gap. In all three cases, changes in the eurozone short-term interest rates strongly drive adjustments in the central banks’ reference interest rates.

Monetary policies in countries converging to a common currency system cannot be based exclusively on discretionary responses to observed or anticipated shocks to inflation and other target variables. Since convergence to a common currency is a multifaceted process that is comprised of closing the gaps in inflation rates and interest rates as well as stabilizing exchange rates, a transparent, forward-looking instrument rule could be helpful for achieving these at times exclusive tasks. Thus far, the literature has not identified a uniform, robust open-economy instrument rule to guide monetary policies in the economies converging to the euro. This study aims at investigating a plausible forward-looking instrument rule for open economies undergoing monetary convergence to a common currency system. Such a policy rule ought to include real interest rate, inflation gap, output gap and exchange rate gap as independent or input variables, which guide changes in short-term interest rates as policy instruments chosen by a central bank. In the case of converging economies, these input variables ought to be devised as differentials between domestic and the corresponding currency area variables in order to monitor and guide the convergence process effectively. The relative treatment of these input variables is consistent with the policy framework of targeting inflation forecast differentials proposed by Orlowski (2008) for converging economies. Thus, in essence, this study examines instrument rules and conditions of their implementation that are consistent with the relative-inflation-forecast-targeting framework. Feasibility of the proposed instrument rule is examined for the three largest countries pursuing convergence to the euro, i.e. for Poland, Hungary and the Czech Republic. In contrast to smaller euro-candidate countries that follow convergence based on currency pegs to the euro, monetary authorities of these larger states have chosen more flexible policy venues based on inflation-targeting. The Czech National Bank (CNB) has been focusing on inflation-targeting since January 1998, the National Bank of Poland (NBP) since January 1999 and the National Bank of Hungary (NBH) since May 2001. As these countries undergo convergence to the euro, their instrument rules for monetary policy cannot be fully autonomous, i.e. based on a simple framework originally proposed by Taylor (1993). Arguably, their central banks do not follow a homogeneous policy prescription (Golinelli and Rovelli, 2005, Orlowski, 2005, Orlowski, 2008 and Jonas and Mishkin, 2005). A forward-looking rule encompassing open, converging economy variables could provide them with useful guidance for monitoring and implementing the euro-convergence process. Section 2 of our paper provides a background discussion on the standard Taylor rule and states assumptions for its extension for open converging economies. Several models of a forward-looking instrument rule that is conducive for such economies are developed and discussed in Section 3. A testable version of the model is presented in Section 4, along with the examination of the degree of stability of the key independent variables in the three euro-candidate countries. Empirical tests of the heteroscedasticity-consistent OLS regression of the underlying instrument rule model are presented and discussed in Section 5. Section 6 summarizes the key findings and offers policy conclusions that seem relevant for the euro-candidate countries.

Devising a monetary policy instrument rule for open economies undergoing convergence to a common currency system and pursuing monetary policies based on inflation-targeting is a complex task. A simple instrument rule in its original form advanced by Taylor (1993) does not adequately reflect hybrid, at times exclusive and contradicting policy objectives for these economies that include price stability, exchange rate stability, convergence to the common currency area interest rates and, in general terms, integration with global financial markets (Jonas and Mishkin, 2005, Orlowski, 2005 and Orlowski, 2008). This study discusses several parsimonious models of policy instrument rules that seem conducive to the conditions of converging economies. Among them are an open-economy instant target interest rate rule and a market-forecast rule. For the EU Member States undergoing convergence to the euro, a more complex interest rate rule that is consistent with the Maastricht convergence criteria is a viable policy option, particularly upon entry in the ERM2. However, its implementation might be difficult to achieve, due to the assumption of several policy objectives that might be exclusive, particularly in the presence of global financial instability. Guided by the objective of monetary convergence to a common currency system (the eurozone), we devise an instrument rule that relates adjustments in the central bank reference rates to the changes in the eurozone short-term interest rate, the inflation gap, the output gap and the exchange rate gap, as prescribed by Eqs. (6) and (7). Our empirical tests based on Eq. (7) demonstrate a high degree of consistency of the CNB interest rate policy with our model, while it is in contrast to the less compliant policies of the NBP and the least of the NBH. In all three countries, adjustments in the central bank reference rates follow closely the actual changes in the eurozone short-term interest rates. Estimations of the remaining input variables in our model point out considerable systemic differences in the monetary policies of the euro-candidates. The central bank reference interest rates in the Czech Republic and Poland respond strongly to the inflation gap, in line with the objectives of the inflation-targeting policies in these countries. In contrast, the reference interest rate in Hungary is insulated from the inflation gap and the output gap, responding strongly to the exchange rate gap. In consistency with the proposed instrument rule conducive to convergence to the euro, further modifications of current monetary policies in the euro-candidate countries, particularly in Hungary and to some extent in Poland, seem to be necessary. Due to systemic differences between these inflation-targeting policies, there is no uniform policy prescription. However, some general guidelines can be specified based on the proposed models for instrument rules. In particular, monetary policies of the euro-candidates ought to be forward-looking, geared toward balancing low inflation and exchange rate stability objectives. For these reasons, some flexibility in adherence to the Maastricht convergence criteria should be allowed.