In this paper, interest-rate smoothing under Taylor-type rules is considered for an empirically plausible two-sector small open economy. A simple Taylor-type rule that has sufficient response to output gap, coupled with interest-rate smoothing, can improve welfare relative to our benchmark historical rule. This result is robust to alternative values of the degree of habit persistence and nontraded-goods price stickiness in the model. Alternatively, the interest-rate smoothing result may not hold when an strictly inflation-forecast-based (IFB) rule is used. However, incorporating sufficient response to contemporaneous output gap and inflation in the IFB rule, interest-rate smoothing can also deliver superior welfare outcomes.
It is often observed that central banks tend to change interest rates in small steps over time; and typically in the same direction for some duration of time. This has come to be known as interest-rate smoothing in the monetary-policy literature.1 An interesting question is how such a behavior of the central bank affects business-cycle fluctuations and therefore welfare in a small open economy, since this behavior has sometimes been considered to be central-bank caution at best, or timidity, at worst. Rotemberg and Woodford (1999) show that, in the context of simple policy rules in a closed economy, policies where there is a smoothing of the rate of interest-rate change can be optimal under certain classes of policy rules and parameterization.
The contribution in this paper is the study of welfare effects, in the context of a richer, microfounded and empirically plausible small open economy, arising from simple monetary-policy rules with interest-rate smoothing. This is an important question for the design of simple monetary-policy rules in a small open economy. Popular models used in the small-open-economy monetary policy literature are often small in scale, featuring fully-traded goods and hence retain full purchasing power parity (see e.g. Galí and Monacelli, 2005 and Clarida et al., 2001). These models also neglect capital and investment dynamics. Our model possesses costly capital accumulation, habit formation in the style of Campbell and Cochrane (1999), and sticky nontraded-goods prices.
Fuhrer (2000) shows how habit persistence can improve the empirical plausibility of models with monetary policy. McCallum and Nelson (1999) also introduce a simple habit-formation process in their small open economy to improve the model’s dynamics. Choi and Jung (2003) show that, within a simple small-open-economy setup of Galí and Monacelli (2005), a policy rule with an interest-rate smoothing term can arise as a result of optimal monetary policy in the presence of habit formation. Unlike the simple model of Choi and Jung (2003), we allow for explicit interest-rate smoothing under an operational rule, and in a more realistic model. We allow for nontraded goods, creating deviations from purchasing power parity. The intuition from Hau (2000) is that with a larger share of nontradables in the CPI money-market equilibrium requires large exchange rate adjustments to support a smaller fraction of tradables. Jung (2000) also makes use of the nontradable goods assumption in conjunction with sticky prices. However, Jung (2000) considered a model where monetary policy is conducted as a money growth rule. Here we focus on monetary policy using an interest-rate rule.
Our experimental strategy is as follows. First, we construct and calibrate a theoretical model which is empirically plausible, nesting a simple monetary-policy rule representing the operational rule which would have been used had it actually been employed by our central bank of interest. Second, using the preceding environment as the welfare benchmark, we consider alternative rules and their implied welfare and business-cycle volatility performance relative to this benchmark. Here we focus on the role of interest-rate smoothing. In our experimental results, a simple Taylor-type rule that has sufficient response to output gap, coupled with interest-rate smoothing can improve welfare relative to our benchmark rule. This result is robust to alternative values of the degree of habit persistence and price stickiness in the model. Alternatively, we also consider a rule that responds to forecast inflation rather than contemporaneous inflation. Unlike Batini and Haldane (1999), we consider inflation-forecast-based (IFB) rules in a model with explicit microfoundations. We find that if the strictly IFB rule responds aggressively to forecast inflation while there is interest-rate smoothing, welfare is lower than our benchmark. Modifying this rule, to admit a nontrivial response to contemporaneous output gap and inflation, we find a welfare-improving case for interest-rate smoothing.
The remainder of the paper is organized as follows. We discuss the model’s economic environment in Section 2. The model is then calibrated and compared with actual Australian data to assess its empirical plausibility in Section 3. We then consider the cases when interest-rate smoothing is beneficial for the economy and perform some sensitivity analysis on the result in Section 4. We conclude in Section 5.
In this paper, simple monetary-policy rules for an empirically plausible small open economy model with traded and nontraded goods are considered. These alternative rules imply welfare and business-cycle volatilities that differ relative to a benchmark empirically plausible rule for a small open economy. In our experimental results, a simple Taylor-type rule that has sufficient response to output gap, coupled with interest-rate smoothing can improve welfare relative to our benchmark rule. This result is robust to alternative values of the degree of habit persistence and price stickiness in the model. We also considered a rule that responds to forecast inflation rather than contemporaneous inflation. We find that if the rule responds aggressively and strictly to forecast inflation while there is interest-rate smoothing, welfare is lower than our benchmark. Modifying this rule, to admit a nontrivial response to contemporaneous output gap and inflation, we can also find a welfare-improving case for interest-rate smoothing.
