RDP 9806: Policy Rules for Open Economies 7. Conclusion

In a closed economy, inflation targeting is a good target rule and a Taylor rule is a good instrument rule. In an open economy, however, these policies perform poorly unless they are modified. The policy instrument should be a Monetary Conditions Index based on both the interest rate and the exchange rate. The weight on the exchange rate should be equal to or slightly greater than this variable's relative effect on spending. As a target variable, policy-makers should use ‘long-run inflation’ – an inflation variable purged of the transitory effects of exchange-rate fluctuations. This variable should also replace inflation on the right side of the instrument rule.

Several countries currently use an MCI as their policy instrument. In addition, some appear to have moved informally toward targeting long-run inflation, for example by keeping inflation below target when a depreciation is expected. It might be desirable, however, to make long-run inflation the formal target variable. In practice, this could be done by adding an adjustment to calculations of ‘underlying’ inflation: the effects of the exchange rate could be removed along with other transitory influences on inflation. At least one private firm in New Zealand already produces an underlying inflation series along these lines (Dickens 1996).