Abstract

This article studies the extent to which open economies conduct monetary policy differently from economies that are relatively closed to international trade. I first estimate country-specific Taylor rules for 26 economies, following the approach of Clarida, Galí, and Gertler (1998 and 2000). Then, I examine the extent to which open economies assign systematically different weights to changes in economic outcomes, such as inflation and the output gap, than their closed economy counterparts do. I find that open economies respond less strongly to changes in expected inflation than relatively closed economies do and that the response to changes in the output gap is independent of the degree of trade openness. Moreover, I find that this difference between closed and open economies may be accounted for by the higher weight open economies give to changes in the real exchange rate, whereby these economies are more likely to decrease the nominal interest rate when the real exchange rate is relatively appreciated.

Fernando Leibovici is an economist at the Federal Reserve Bank of St. Louis. The author thanks Jonas Crews for excellent research assistance and Ana Maria Santacreu for helpful discussions.

INTRODUCTION

Open economies are typically exposed to different sources of shocks than economies relatively closed to international trade¹: To the extent that a country trades goods with the rest of the world, economic conditions in its trade partners and changes in international relative prices may affect domestic economic activity. Insofar as central banks design monetary policy to moderate business cycle fluctuations, the different nature of business cycles in open economies has led many to ask, to what extent should central banks in open economies conduct monetary policy differently from their closed-economy counterparts?

In a recent study, Leibovici and Santacreu (2015) find that openness should indeed be an important consideration for the design of monetary policy. In particular, we show that international trade fluctuations play a key role in accounting for the optimal monetary policy that central banks in open economies should conduct. This finding suggests that trade openness should be a key factor in optimal monetary policy design.

More generally, while theoretical studies have also largely concluded that open economies should indeed conduct monetary policy differently, studies differ in their policy recommendations. On the one hand, Clarida, Galí, and Gertler (2002) and Corsetti, Dedola, and Leduc (2010) show that in a specific class of economic models the design of monetary policy in open economies is "isomorphic" to the conduct of monetary policy in a closed economy: Central banks should only respond to changes in inflation and the output gap, but they may respond differently to these depending on the degree of trade openness. On the other hand, more- recent studies have shown that this need not necessarily be the case in more realistic environments (Faia and Monacelli, 2008, De Paoli, 2009, and Lombardo and Ravenna, 2014) in which central banks in open economies may also want to respond to changes in other variables such as the real exchange rate.

Yet, while much work has been devoted to understanding the normative question about whether and how central banks in open economies should design monetary policy differently from their closed-economy counterparts, much less is known about the positive question on whether they do indeed conduct policy differently. Therefore, in this article I ask, to what extent do central banks of open economies conduct monetary policy differently from those of closed economies?

The answer to this question has important implications. To the extent that the relationship between trade openness and monetary policy observed in the data differs from the relationship implied by the optimal policy analysis of structural economic models, this may suggest that some countries are indeed conducting monetary policy suboptimally. Alternatively, to the extent that central banks of open economies conduct monetary policy differently from that implied by standard models, this may reflect economic channels or concerns of policymakers that may not be explicitly considered in the economic models, but which may yet be important for understanding the link between trade openness and monetary policy.

The goal of this article is, thus, to investigate the empirical relationship between trade openness and the design of monetary policy using cross-country time-series data for the period 1980 to 2006. In the first step of the analysis, I compute empirical measures that allow me to characterize and compare the nature of monetary policy across different countries over this period. Then, I use these empirical measures to examine whether open economies conduct monetary policy differently from closed economies.

My starting point to characterizing the nature of monetary policy across countries is the standard Taylor rule (1993), which specifies a link among nominal interest rates, inflation, and the output gap. While an increasing number of countries use the nominal interest rate as their preferred instrument for the conduct of monetary policy combined with some sort of inflation and/or output-related targets, the approach I take here is more broad. In particular, in this article I do not interpret the Taylor rule coefficients as structural parameters that govern the response of interest rates to changes in inflation and output but, instead, use the Taylor rule as a device to summarize the statistical properties of how interest rates, inflation, and output behave in the time series across countries regardless of the particular underlying monetary policy instruments, outcome-targeting regimes, or exchange rate regimes in place in each country. 

The goal of this approach is to characterize monetary policy across countries through a common lens in order to facilitate cross-country comparability. This advantage comes at the cost of forcing the analysis to abstract from differences in monetary policy across countries not captured by differences in the empirical Taylor rule coefficients.

Thus, I first estimate country-specific Taylor rules for 26 countries with differing degrees of openness to international trade (as measured by the ratio of aggregate exports to gross domestic product [GDP]) using time-series data on interest rates, inflation, and output. I follow the generalized method of moments (GMM) approach of Clarida, Galí, and Gertler (1998 and 2000), which allows me to obtain estimates of the explicit or implicit response of interest rates to changes in inflation and the output gap. Then, I examine whether the statistical relationship among interest rates, inflation, and output differs systematically based on the degree of trade openness.

I begin the analysis by considering a baseline specification of the Taylor rule, which specifies the relationship among nominal interest rates, expected inflation, and the current output gap. In addition, I include lagged nominal interest rates, following a large literature that has observed that central banks adjust interest rates gradually over time. I find considerable dispersion across countries in the empirical relationship between nominal interest rates and expected inflation, as well as between nominal interest rates and the output gap. Moreover, I find that these relationships differ systematically across countries based on their degree of international trade openness: Nominal interest rates in open economies respond systematically less to changes in expected inflation than they do in closed economies. I find no systematic relationship between the response of a country's nominal interest rate to changes in its output gap and the degree of the country's openness.

While the lower response of nominal interest rates in open economies to changes in inflation may reflect that such countries are less concerned about inflation, it may also reflect that these countries actually respond to changes in variables other than inflation. To investigate this possibility, I reconduct the analysis, extending the Taylor rule to include a trade-related variable that may affect how open economies conduct monetary policy, as suggested by previous studies (Faia and Monacelli, 2008, and De Paoli, 2009, among others)—the real exchange rate. I find that, indeed, open economies are systematically more likely to adjust their nominal interest rate in response to changes in the real exchange rate.

These findings suggest that open economies do conduct monetary policy differently from their closed-economy counterparts. First, I find that open economies respond relatively less to changes in inflation. Second, I find that open economies respond relatively more to changes in the real exchange rate. And, finally, I find that the degree of interest rate smoothing and the response of nominal interest rates to changes in the output gap do not vary systematically with the degree of international trade openness.

This article contributes to a growing empirical literature that studies the relationship between trade openness and monetary policy, such as Lubik and Schorfheide (2007), Berument, Konac, and Senay (2007), and Basilio (2013). This article is also related to empirical papers aimed at estimating Taylor rules across countries. I follow very closely the estimation approach of Clarida, Galí, and Gertler (1998 and 2000), who apply it to the United States, Japan, Germany, France, Italy, and the United Kingdom. Also related are Torres (2003), Hayo and Hofmann (2006), Yazgan and Yilmazkuday (2007), and Kahn (2012).

More broadly, this article is also related to a large theoretical and quantitative literature that investigates the extent to which open economies should conduct monetary policy differently. Corsetti, Dedola, and Leduc (2010) provide a broad discussion of many of the studies in this literature. More recently, Faia and Monacelli (2008), De Paoli (2009), Lombardo and Ravenna (2014), and Leibovici and Santacreu (2015) investigate this question in richer and more realistic economic environments.

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