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This paper uses a forward-looking open-economy optimizing model to show that the existence of a real exchange rate channel in the Phillips Curve dramatically alters the conduct of optimal monetary policy. The central bank’s optimal reaction function can produce a “lean with the wind” response to domestic IS disturbances and the foreign output gap provided that both a pronounced exchange rate channel exists and the disturbances are highly persistent. The more potent the real exchange rate channel in the Phillips Curve becomes, the greater (smaller) the fluctuations in the output gap (real exchange rate). How this channel affects the variability of the nominal variables depends on the degree of persistence of the disturbances.

In its simplest incarnation, a strategy of flexible inflation targeting requires a central bank to focus on two policy objectives. Apart from stabilizing the rate of inflation, the central bank also pays heed to the state of the real economy. There is increasing evidence that flexible inflation targeting characterizes the conduct of monetary policy even in those countries where the pursuit of price stability is the overriding goal of monetary policy. That strict inflation targeting is not what central banks practice is borne out by the wording of policy targets agreements or formal contracts entered into by the executive branch of government and the head of the central bank. For instance, the policy targets agreements concluded by the Minister of Finance and the Governor of the Reserve Bank of New Zealand, 1999 and Reserve Bank of New Zealand, 2002 stipulate that “[i]n pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate”.1 Other central banks that are viewed as having adopted flexible inflation targeting are the Swedish Riksbank and the Bank of England.2 The Reserve Bank of Australia and the Bank of Canada are also widely acknowledged as practicing flexible inflation targeting, albeit in a less formal way compared to the Swedish Riksbank or the Bank of England. Flexible inflation targeting has also been embraced by central banks in transition economies like the Czech Republic, Hungary, and Poland as well as in emerging countries like Brazil, Chile, Mexico, to name but a few.3 The rationale for minimizing fluctuations in variables other than the rate of inflation derives from the simple realization that a narrow focus on the rate of inflation will cause excessive swings in the nominal interest rate, the exchange rate, and real output. Pronounced volatility of the nominal interest rate and the exchange rate are disruptive to the smooth working of financial markets. Huge swings in real output are not acceptable for economic as well as political reasons.4 The countries currently practicing flexible inflation targeting are typically small open economies.5 The central banks in these countries are assigned an inflation target specified as a numerical value or as a target range for the rate of inflation. By convention, the target proper or band for the rate of inflation is expressed in terms of a percentage point change in the consumer price index (CPI). Thus, the rate of inflation in these countries is determined by domestic and international factors. These factors may pull the rate of inflation in opposite directions. For instance, unexpected strong domestic demand relative to capacity will put upward pressure on the domestic component of CPI inflation. With the interest rate rising, the real exchange rate appreciates and reduces export demand. In addition, the appreciation of the domestic currency lowers the domestic currency price of internationally traded goods, the prices of which are determined in world markets. Thus, the strengthening of the exchange rate leads to offsetting, i.e. downward pressure on CPI inflation provided that the pass-through effect on import prices is direct and swift. It is no surprise then that inflation targeting central banks pay close attention to current and expected future movements in the exchange rate when setting policy.6,7 Indeed, the direction and size of any adjustment in the policy instrument depends on the strength of the effect of domestic vis-à-vis international factors on the rate of CPI inflation. The preceding paragraph has described the standard effect on the CPI inflation rate of a change in the nominal exchange rate. This effect depends critically on the extent of exchange rate pass-through. Although the pass-through effect is an important link in the transmission of changes in the exchange rate on the rate of CPI inflation, it is not the focus of this paper. Instead, this paper considers a distinctly different exchange rate channel. The exchange rate channel emphasized in this paper traces the immediate effect of a change in the level of the real exchange rate on domestic inflation. This exchange rate effect on domestic inflation arises because domestic firms take the price of the internationally traded consumption good as a benchmark for setting the domestic price of same. Ideally, domestic firms would set the price of the consumption good produced equal to the optimal price which responds to marginal cost and the exogenous benchmark price. However, this does not happen as there are menu costs that inhibit the operation of complete domestic price flexibility. To illustrate the combined effect of sticky domestic prices and benchmark pricing in a small open-economy, consider the following scenario. Suppose the domestic currency depreciates which in the current context implies that the nominal exchange rate increases. This increase leads to a one-for-one increase in the benchmark price – expressed in domestic currency – of the internationally traded consumption good. The optimal price that firms charge rises in line with the benchmark price. This in turn induces domestic firms to raise their prices, thus imparting upward pressure on the domestic rate of inflation. To what extent the depreciation of the nominal exchange rate, which also leads to a depreciation of the real exchange rate, results in an increase in the domestic rate of inflation depends on the importance of menu cost relative to the cost of being away from the optimal price. The importance of a benchmark price in influencing price-setting behavior has recently been highlighted by Taylor, 2000 and Bergin and Feenstra, 2000 in contributions that do not deal with optimal monetary policy considerations. Indeed with the exception of Walsh, 1999 and Guender, 2006 the literature to date has not considered analytically the implications for optimal monetary policy of the existence of a real exchange rate effect in the New Keynesian Phillips Curve.8,9 In this paper, we present a formal analysis of the behavior of a central bank that practices flexible inflation targeting in a small open-economy where a real exchange rate channel in the Phillips Curve is operative. The central bank acts with discretion and frames its flexible inflation targeting strategy around the rate of domestic inflation and the output gap. 10 The key behavioral assumptions about the central bank are that it is forward-looking and optimizing in the sense of seeking to minimize its intertemporal loss function with respect to the target variables. Optimizing behavior on the part of the central bank gives rise to two first-order conditions that, when combined, characterize the targeting strategy of the central bank. With the systematic relationship between the target variables being established, it is a short step to recover the optimal reaction function of the central bank. The optimal reaction function shows how the central bank varies mechanically the setting of the policy instrument, the nominal interest rate, in response to the shocks that occur in the open-economy framework. The existence of a real exchange rate channel in the Phillips Curve has a few noteworthy implications for the conduct of monetary policy under flexible inflation targeting. First, its existence alters dramatically the relative weight the policymaker places on the output gap in the target rule. The optimizing condition that characterizes the systematic relationship between the target variables is shown to depend on both IS and Phillips Curve parameters. This result stands in marked contrast to the result that obtains in the closed-economy framework or in a model of an open-economy where a real exchange rate channel in the Phillips Curve is not operative. Second, the existence of such an exchange rate channel on the supply-side of the economy may lead the policymaker to decrease the nominal interest rate in the wake of a positive domestic IS disturbance or a positive foreign output gap. Such a “lean with the wind” response can come about because the determination of the rate of inflation is subject to domestic and international factors. A “lean with the wind” reaction is the more likely the more potent the real exchange rate becomes and the greater the degree of persistence of the disturbances that impinge upon the economy. Finally, the analytical results also underscore the important role of the persistence parameter in determining the effect of a more potent real exchange rate channel on the variability of the nominal variables of the model. Whether the variability of domestic inflation, CPI inflation and the nominal interest rate, respectively, rises or falls as the potency of the real exchange channel increases hinges critically on the degree of persistence of the disturbances. In sharp contrast, there is no ambiguity concerning the effect of persistence and an increasingly stronger real exchange rate channel in the Phillips Curve on the behavior of the real variables of the model: The variability of the output gap increases while the variability of the real exchange rate decreases. The remainder of the paper is organized as follows. Section 2 lays out the model. Section 3 analyzes the conduct of optimal monetary policy. The optimal reaction function is described in Section 4. The behavior of the policy instrument, the real exchange rate, the output gap, and the two rates of inflation is examined in Section 5. The findings of the paper are summarized in Section 6.

This paper underscores the important role of the real exchange rate in the conduct of optimal monetary policy in a small open-economy. The importance of the real exchange rate in the policy process arises from its key role in the setting of domestic prices. In small open economies, domestic price setters take the world price of the internationally traded consumption good as a benchmark price. A depreciation of the domestic currency causes cost-minimizing firms to raise their prices, thereby forcing up the domestic rate of inflation. The existence of a real exchange rate channel in the Phillips Curve dramatically alters the conduct of optimal policy under discretion in the open-economy framework. The optimizing condition that characterizes the systematic relationship between the target variables depends on parameters of both the IS and the Phillips Curve as well as the policymaker’s preferences. This paper highlights the importance of the degree of persistence of the stochastic disturbances in the implementation of optimal monetary policy under discretion. If paired with a potent real exchange rate channel in the Phillips Curve, a high degree of persistence may explain why in the open-economy framework the setting of the policy instrument responds less forcefully to a domestic IS disturbance or the foreign output gap than in the absence of this exchange rate channel. Indeed, the degree of persistence and the size of the parameter on the real exchange rate in the Phillips Curve determine whether the policymaker raises or lowers the nominal interest rate in response to a positive domestic IS shock or a positive foreign output gap. The possibility of a “lean with the wind” policy response is inconceivable in the closed-economy or standard open-economy model where the Phillips Curve does not feature a real exchange rate channel. Finally, the examination of optimal discretionary monetary policy in an open-economy setting reveals that for a given degree of persistence of the disturbances, the strength of the real exchange rate channel in the Phillips Curve affects the variability of the real variables of the model in a systematic fashion. The variability of the output gap increases while the variability of the real exchange rate decreases as the potency of the real exchange rate channel in the Phillips Curve increases. No such predictable pattern exists for the nominal variables of the model. The results indicate that, ceteris paribus, the variability of domestic inflation, CPI inflation, and the nominal interest rate are lower in economies where a potent real exchange rate channel exists provided that the persistence of the disturbances is moderate. In contrast, at very high levels of persistence an economy where a real exchange rate channel in the Phillips Curve is very potent is subject to greater fluctuations in the three nominal variables compared to an economy where the real exchange rate channel in the Phillips Curve is weaker or does not exist at all. This paper considers only the conduct of optimal monetary policy under discretion in an open-economy New Keynesian framework. A topic for further study is the way the target rule and the reaction function change under policy from a timeless perspective in the presence of a real exchange rate channel in the Phillips Curve. This special form of time-consistent policy under commitment introduces inertia and history dependence into the conduct of monetary policy. More specifically, lags of the target variables enter both the target rule and the reaction function. This being the case, optimal policy from a timeless perspective should lead in an open-economy framework – just as it does in a closed-economy – to more efficient outcomes for society than optimal policy under discretion.