Asymmetric Monetary Policy Rules for an Open Economy: Evidence from Canada and the UK

• Date: 01 July 2016
• Published date: 01 July 2016
• Author: Kostas Mouratidis,Zainab Jehan,Mustafa Caglayan
• DOI: http://doi.org/10.1002/ijfe.1547

INTERNATIONAL JOURNAL OF FINANCE AND ECONOMICS

Int. J. Fin. Econ.21: 279–293 (2016)

Published online 17 February 2016 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1547

ASYMMETRIC MONETARY POLICY RULES FOR AN OPEN ECONOMY:

EVIDENCE FROM CANADA AND THE UK

MUSTAFA CAGLAYAN,, ZAINABJEHAN and KOSTAS MOURATIDIS

School of Management and Languages, Heriot-WattUniversity, Edinburgh EH14 4AS, UK

Department of Economics, Fatima Jinnah Women University, Rawalpindi, Pakistan

Department of Economics, University of Sheffield, Sheffield, UK

ABSTRACT

We present an analytical framework to examine the open economy monetary policy rule of a central bank under asymmetric

preferences. The resulting policy rule is then empirically examined using quarterly data with regard to Canada and the UK from

1983q1 to 2007q4. Our empirical investigation shows that the open economy policyrule receives support from the data and that

the monetary policy makers in the UK and Canada have asymmetric preferences. Robustness checks based on model calibration

provide support for the suggested policy rule. Copyright © 2016 John Wiley & Sons, Ltd.

Received 05 May 2015; Revised 17 January 2016; Accepted 18 January 2016

KEY WORDS: monetary policy rules; asymmetric preferences; open economy; calibration; econometrics

1. INTRODUCTION

It is well accepted that monetary policy plays an essential role in providing a stable macroeconomic background to

facilitate the efficient allocation of resources. To demonstrate that such an economic environment can be achieved

by adopting an optimal monetary policy framework, researchers have proposed several alternative models. For

instance, a large number of studies advocate the adoption of inflation targeting and its implementation through

variants of the Taylor rule.1Yet, researchers have mainly focused on closed economy models arguing that the

impact of foreign factors on the monetary policy is small and that their effects can be excluded.2

However, given that exchange rates respond to foreign disturbances and, as a result, affect domestic prices,

it is somewhat surprising to overlook the importance of exchange rate movements on the monetary transmission

mechanism. To that end, Ball (1999b) shows that although the variants of the Taylor rule are optimal in a closed

economy framework, these policies perform poorly in an open economy unless they are modified to account for the

movements in the exchange rates. Svensson (2000) argues that the optimal reaction function in an open economy

accounts for more information than that in a closed economy. He discusses the presence of various direct and

indirect channels through which the exchange rate can affect monetary policy and shows that consumer price index

(CPI) inflation responds to foreign variables including the foreign inflation rate, the foreign interest rate, exchange

rate and shocks from the rest of the world. Many other researchers, including Gali and Monacelli (2005), Lubik and

Schorfheide (2007) and Adolfson et al. (2008), implement open economy DSGE models and show that exchange

rate movements affect central bank behaviour.

Researchers have also been challenging the common assumption that policy makers minimize a quadratic loss

function subject to a linear IS equation and a linear Phillips curve. Cukierman and Gerlach (2003) suggest that a

central bank responds strongly to inflation when the economy is expanding and to the output gap when the economy

is contracting. Dolado et al. (2005) relax the assumption of a linear Phillips curve, allowing for both inflation and

the loss function to be convex functions of the output gap. Several other researchers, including Nobay and Peel

(2003), Ruge-Murcia (2000,2003), Dolado et al. (2004) and Surico (2003,2007), have also assumed that central

Correspondence to: Mustafa Caglayan, School of Management and Languages, Heriot-Watt University, Edinburgh EH14 4AS, UK.

E-mail:m.caglayan@hw.ac.uk

Copyright © 2016 John Wiley & Sons, Ltd.