Monetary Policy Rules for an Open Economy Nicoletta Batini* Richard Harrison** and Stephen P. Millard < First draft: December 1999 This draft: May 2000 Preliminary and Incomplete (Please do not quote without the authors’ permission) Abstract The most popular simple rules for the interest rate, due to Taylor (1993a) and Henderson and McKibbin (1993), are both meant to inform monetary policy in economies that are closed. On the other hand, their main open economy alternatives, based on a Monetary Conditions Index (MCI) are potentially flawed for a number or reasons, not least because they fail to adequately allow for different types of exchange rate shocks when setting policy. In this paper we derive simple monetary policy rules that are suitable for small open economies in general, and for the UK in particular. We do so by comparing the performance of a battery of complex and simple rules, including the familiar Taylor and Henderson and McKibbin rules and MCI-based rules. This entails comparing the asymptotic properties of a two-sector open-economy dynamic stochastic general equilibrium model calibrated on UK data under different rules. We find that a good simple rule is one that responds to changes in the real exchange rate in addition to output and inflation. This does not imply having a target on the exchange rate, but rather suggests that it may be useful to exploit its indicator properties in the pursuit of domestic objectives. * Research Adviser, MPC Unit, Bank of England, Threadneedle Street, London EC2R 8AH, United Kingdom. Tel: +44 20 76014354. Fax: +44 20 76013550 E-mail: nicoletta.batini@bankofengland.co.uk (corresponding author) ** Analyst, Monetary Assessment and Strategy Division, Monetary Analysis, Bank of England, Threadneedle Street, London EC2R 8AH, United Kingdom. Tel: +44 20 76015662. Fax: +44 20 76014177. E-mail: richard.harrison@bankofengland.co.uk < Manager, Monetary Instrument and Markets Division, Monetary Analysis, Bank of England, Threadneedle Street, London EC2R 8AH, United Kingdom. Tel: +44 20 76014115. Fax: +44 20 76014177. E-mail: stephen.millard@bankofengland.co.uk We thank Nicola Anderson, Spencer Dale, Shamik Dhar, Rebecca Driver, Chris Erceg, Neil Ericsson, Jeff Fuhrer, Andy Levin, Bennett McCallum, Katherine Neiss, Edward Nelson, Glenn Rudebusch, Chris Salmon, Anthony Yates and seminar participants at the Bank of England for useful comments on earlier versions of this paper. Remaining errors, and the views expressed herein are those of the authors and not of the Bank of England nor of the Bank of England’s Monetary Policy Committee.