comment on: a simple framework for international monetary policy analysis

Journal of Monetary Economics 49 (2002) 905–912

Comment on:A simple framework for international

monetary policy analysis$

Edward Nelson*

Monetary Policy Committee Unit, Bank of England, Threadneedle Street, London EC2R 8AH, UK

Received 16 November 2001; received in revised form 22 February 2002; accepted 23 February 2002

1. Introduction

In his Theory of International Economic Policy, J.E. Meade (1951, p. 106) made thefollowing prescription for monetary policy in an open economy.

It may be that the best form of financial policy for internal balance would be tomaintain total domestic expenditure at such a level as to ensure sufficient demandfor home-produced goods and services in general as to maintain constant thegeneral index of prices offered for all home production, and to insist uponsufficient upward and downward adjustments of particular money wage ratesagainst this general background of stability, to avoid general unemploymentand—together with other appropriate measures to encourage the mobility oflabor and of enterprise between different industries and localities—to reducestructural unemployment to the minimum.

The monetary policy prescription for an individual open economy reached byClarida, Gal!ı, and Gertler (CGG) (2002) is similar to Meade’s of a half-centuryearlier: target domestic-goods price inflation; allow the relative-price adjustmentnecessary to keep output equal to potential (a condition corresponding to absence of‘‘general unemployment’’ in Meade’s terminology); and use microeconomic policy toensure that potential output reaches its efficient level (a subsidy in CGG, serving toapproximate the ‘‘appropriate [nonmonetary] measures’’ advocated by Meade).

$I thank Amit Kara and Marilyne Tolle for research assistance. The opinions expressed in this paper

are mine alone and should not be interpreted as those of the Bank of England or the Monetary Policy

Committee.

*Tel.: +44-20-7601-5692; fax: +44-20-7601-3550.

E-mail address: [email protected] (E. Nelson).

0304-3932/02/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved.

PII: S 0 3 0 4 - 3 9 3 2 ( 0 2 ) 0 0 1 2 9 - 0

While there is continuity in policy prescription with Meade, CGG’s modellingapproach is, of course, very different. Using the best available modern tools, CGGconduct policy analysis with a model that is explicitly dynamic, stochastic, andoptimization-based. In keeping with the new open-economy macroeconomics(NOEM) literature, CGG’s model features optimal consumption and asset choicesby the private sector, as well as sticky goods prices. But unlike most of the NOEMliterature published to date, the model specifies price setting and policy behavior in amanner more consistent with the closed-economy work on sticky-price generalequilibrium models, as described in CGG (1999). In line with their (2001) analysis ofthe small open economy case, CGG obtain an ‘‘isomorphism’’ result connectingclosed and open-economy monetary policy analysis. Section 2 of my commentsdiscusses this isomorphism result and argues that while the aggregate demand aspectof this isomorphism is uncontroversial, the isomorphism regarding the Phillips curvecould be questioned, both positively and normatively. The positive issue is discussedin Section 3, which argues that the implied behavior of CPI inflation in CGG’s modelis inconsistent with data for the United Kingdom, and so propositions that rely on astrong distinction between domestic and CPI inflation might be questioned. In lightof this and other considerations discussed in Section 4, the superiority of domesticinflation targeting to CPI inflation targeting is less clear. I briefly discuss CGG’sresults for the cooperative case in Section 5, while Section 6 concludes.

2. The isomorphism result

A key result arising from CGG’s analysis is the ‘‘isomorphism’’ they find betweenclosed-economy and open-economy monetary policy analysis. This isomorphism canbe split into that for aggregate demand and that for pricing behavior, and I discusseach in turn.

Consider first the isomorphism result for the aggregate demand portion of themodel. The relation describing output-gap behavior in the open economy, CGG’sEq. (49), can be written without explicit reference to the exchange rate. This result isuncontroversial. That the relation between net export demand and the real exchangerate, together with the interest sensitivity of the exchange rate, makes the IS curve‘‘flatter’’, is familiar from textbook treatments of traditional open-economy IS-LManalysis. Most of these treatments, however, go overboard by presenting thesituation for a small open economy as one corresponding (when financial marketsare internationally integrated) to a perfectly horizontal IS curve—implying not onlythat the domestic monetary authority has no influence over the short-term realinterest rate, but that its open market purchases can have large effects on outputwithout leaving any imprint on market interest rates.1 This way of representing theimpact of openness, while valid under restrictive conditions regarding goods and

1For example, Auerbach and Kotlikoff (1995, p. 486), in a figure labelled ‘‘Why monetary policy is

more effective in an open economy’’, depict a monetary expansion as leading in a closed economy to a

substantial fall in the real interest rate, but having no effect on the real rate in an open economy.

E. Nelson / Journal of Monetary Economics 49 (2002) 905–912906

asset market behavior, seems highly inappropriate for analysis of actual monetarypolicy in open economies (both small and large), as central banks certainly regardthemselves as exerting considerable influence on the short-term real rate, and believethat this influence is a crucial source of monetary policy effects.

A more realistic representation of policy, in keeping with CGG’s analysis, is thatthe central bank can continue to influence the short-term real interest rate in an openeconomy, and that the net trade channel means that a larger movement in domesticoutput can be accomplished for any given change in the short real rate. This resulthas been used in previous work with closed-economy general equilibrium models as away of approximating open-economy effects. For example, Neiss and Nelson (2000)exploit the fact that the Euler and UIP conditions imply consumption and netexports have similar relationships to the real interest rate, to justify using an ISequation without an explicit real exchange rate term in monetary policy analysis forsmall open economies.2

A vital element underpinning the central bank’s ability to have long-lasting,though temporary, effects on the real interest rate and other real variables is thepresence of price stickiness. The one-period price stickiness used in the Obstfeld andRogoff (1995) model (see also Lane, 2001) precludes monetary policy effects on thereal rate, or deviations of output from its potential value, beyond the current period.Because all goods prices can adjust costlessly to shocks after one period, expectedfuture inflation responds to insulate the real rate from monetary policy actions; andthe economy jumps to its flexible-price equilibrium at the end of the current period,ruling out long-lasting output gaps in response to monetary policy actions. Richerprice dynamics, such as those of the Calvo (1983) pricing that CGG use, have thetwin advantages of permitting the analysis of interest rate rules for open economiesand of implying more realistic, protracted real effects of monetary policy.3

CGG’s specification of pricing behavior leads to a second, and I believe lessgeneral, isomorphism result. They find that CPI inflation does not appear in any ofthe structural equations needed to compute household welfare. Beside the ISrelation, the only equation needed for this purpose is the Phillips curve for domesticgoods prices.

The resulting small system gives striking welfare implications. The nominalrigidities underlying the Phillips curve are an incipient source of output gaps—deviations of output from its flexible-price equilibrium level. With flexible-priceequilibrium output corresponding to the efficient level (at least if supported byappropriate subsidies, as in CGG), the optimal role for monetary policy is to cancelout the effects of nominal rigidities. The associated policy creates demand and costconditions that imply no pressure to move on those prices that are sticky, so that the

2The condition Neiss and Nelson obtain is a proportional relation between the level of real aggregate

demand (relative to its future value) and the short-term real interest rate, as conventionally defined,

whereas CGG’s (2001, 2002) isomorphism result relates the output gap to the difference between a real

rate defined using the domestic-inflation concept, and its corresponding ‘‘natural’’ value.3Early work with NOEMmodels that moved to dynamic price stickiness and interest-rate rules includes

McCallum and Nelson (1999) and Svensson (2000), while Gal!ı and Monacelli (2000) and Kollmann (2001)

are early applications to NOEM models of the Calvo price-setting scheme.

E. Nelson / Journal of Monetary Economics 49 (2002) 905–912 907

impediments to adjustment of those prices do not, in fact, produce costly deviationsof the economy from its flexible-price equilibrium. In a closed-economy modelwithout a flexible-price goods sector, the stickiness applies to the whole of the priceindex, and so CPI inflation targeting is optimal.4 In CGG’s open-economy model, onthe other hand, domestic goods prices are sticky but imported goods are flexible-price; it is then optimal for an individual central bank to target domestic rather thanCPI inflation.

According to CGG’s model, therefore, CPI inflation targeting is a misguidedpolicy for an open economy. But as Svensson (2000, pp. 157, 159) observes, ‘‘all real-world inflation-targeting economies are quite open economies’’ and ‘‘all inflation-targeting countries have chosen to target CPI inflationyNone of them has chosen totarget domestic inflationy’’ I argue below that there are grounds for believing thatCPI inflation targeting in open economies is not misguided. I first show that CGG’smodel does not provide a reliable description of actual CPI inflation dynamics in anopen economy (namely, the United Kingdom), and so propositions based on themodel regarding CPI inflation might be questioned. Then I argue that CPI inflationtargeting in practice avoids the inefficiencies found by CGG to characterize thatpolicy.

3. CPI inflation dynamics in CGG’s model

Though CPI inflation is not one of the variables that need to be monitored forwelfare evaluation in CGG’s model, their model does imply restrictions on CPIinflation dynamics. Let pd denote quarterly domestic inflation, pc quarterly CPIinflation, g the share of imports in the CPI, mc log real marginal cost, and tt the logterms of trade. The expression for CPI inflation is

pct ¼ pdt þ g Dtt; ð1Þ

while CGG’s domestic-inflation Phillips curve is

pdt ¼ bEtpdtþ1 þ dmct: ð2Þ

Under CGG’s assumption of full pass-through, ttt can be replaced by the log realexchange rate, which I denote qt: Combining (1) and (2) and making thissubstitution, lead to the following equation describing CPI inflation behavior:

pct ¼ bEtpctþ1 þ dmct þ gðDqt � bEt Dqtþ1Þ: ð3Þ

According to Eq. (3), CPI inflation depends on its expected next-period value, oncurrent real marginal cost, and on the change in the real exchange rate relative tonext period’s expected change.

In order to determine the empirical validity of this description of CPI inflationdynamics, I estimate Eq. (3) on quarterly UK data. Following Gal!ı and Gertler’s(1999) work on closed-economy Phillips curves, I use instrumental variables

4See Aoki (2001), King and Wolman (1999), and Woodford (2001) for further discussion.


estimation. mc and q are measured in conformity with their definitions in the CGGmodel, so domestic price indices (where available) are used in generating realmarginal cost and the real exchange rate, and the latter series is measured in unitssuch that an increase is a depreciation.5 One difference, however, is that I measure pc

and Dq empirically as annualized quarterly percent changes in the CPI and the realexchange rate, respectively. Consequently, the estimated coefficient on mc

corresponds to 4d in CGG.The estimates appear in Table 1. The estimate of b; the discount factor, is of

reasonable magnitude and high significance, and the coefficient on mc; while notquite reaching significance, is at a plausible value. But the coefficient on the realexchange rate term is wrongly signed, and, moreover, quite close to statisticalsignificance. The results cast doubt on the ‘‘important distinction between CPIinflation and domestic inflation’’ stressed by CGG. If anything, CPI inflation in thedata appears to behave like domestic inflation in CGG’s model: unit labor costs seemto matter, but exchange rates do not enter in a meaningful way. Undoubtedly, theassumption of complete and instant pass-through of exchange rate changes toimport prices is one source of the problems with these estimates. Models that allowfor incomplete pass-through and more dependence of import prices on domesticmacroeconomic conditions might better describe CPI inflation behavior (Bursteinet al., 2002; Engel, 2002). In any event, Table 1 indicates that CGG’s propositionsregarding the choice between CPI and domestic inflation targeting need to be treated

Table 1

Estimates of Eq. (3)

United Kingdom, quarterly data, 1964Q1–2001Q2.

Dependent variable: annualized consumer price inflation (RPIX).

IV estimation

Specification : pct ¼ bEtpctþ1 þ dmct þ gðDqt � bEt Dqtþ1Þ þ const:

Coefficient

b 0.962

(0.104)

d 0.338

(0.239)

g �0.130

(0.072)

Note: Standard errors in parentheses. Because inflation is in annualized units, the estimate of dcorresponds to 4 times the corresponding coefficient in CGG’s model. Estimated specification includes

constant and dummy variables for shifts in measured inflation due to tax changes in 1974, 1979, and 1990.

Instrument list includes these dummies plus a constant, lags 1–5 of inflation, and lags 1–3 of mc and Dq:

5The marginal cost series used is based on Batini et al.’s (2000) labor share data.


with caution, because their model does not appear to provide a reasonabledescription of actual CPI inflation in open economies.

4. Benefits of CPI inflation targeting

Let us now consider some possible reasons why CPI inflation targeting as followedin practice corresponds to or approximates optimal monetary policy, even underCGG’s assumption of complete pass-through.

The disadvantage of CPI inflation in CGG’s framework is that when consumerprices—the aggregate of domestic and imported goods prices—are smoothed,desirable movements in the relative price of imports, and the associated changes inreal quantities, are inhibited. In practice, however, inflation-targeting policymakersdo recognize the need for relative-price changes to facilitate the efficient allocation ofgoods and input supplies in response to shocks; and that these relative-price changestend to imply short-run movements in aggregate CPI inflation. Such changes arepermitted by tolerating deviations of CPI inflation from target in the short run, whilerequiring that inflation converge to target over a horizon. For example, the UK’sMonetary Policy Committee recently observed: ‘‘In the short runychanges inrelative prices can lead to changes in measured aggregate inflationy[But] ifaggregate demand and supply conditions are unchangedy changes in relative pricestell us little about underlying inflationary pressure. The Committee has judged thatsome of the recent movements in inflation have reflected relative price changes.’’(Monetary Policy Committee, 2001, p. 37).

Another reason for thinking that CGG’s results understate the desirability of CPItargeting is the absence of shoe-leather costs from inflation to households in theirmodel. The expression for utility in CGG’s model does not include a term in realmoney balances. But the ability of the monetary authority to manipulate nominalinterest rates in the model implies an underlying demand in the private sector fornominal base money. Such a demand is usually taken to be based largely on thetransactions services, and thus utility, derived from the availability of a medium ofexchange in purchases of consumer goods. The resulting utility comes from the realmoney balances associated with the nominal holdings, and the price index relevantfor computing these real balances is unambiguously the CPI, since that correspondsto the price of households’ consumption bundles. One justification for neglecting thissource of costs of inflation is that it becomes negligible as households’ reliance onbase money for transactions diminishes, approaching the ‘‘cashless limit’’ ofWoodford (1998). But in economies such as the US and the UK, the long-termpostwar decline in the demand for base money relative to income appears to havestopped and begun to reverse. So it is not clear that the benefits of CPI inflationtargeting arising from the shoe-leather source should be neglected.

Perhaps most important, CGG’s findings against CPI inflation targeting are basedon a model in which imports are treated as final consumer goods. In small-scaleNOEM models, it may be valid, and even preferable, to treat imports instead asserving only as intermediate inputs in production. While the exclusion of imported


consumer goods from a model may seem jarring at first sight, it is less so when onenotes that, as Wilson (1976, p. 5) put it,

all imports require the services of domestic factorsy [and] all domestic output, orvirtually all, requires imported inputs at some stage in the production process.

If, as in McCallum and Nelson (1999), all final goods are produced using a mix ofdomestic factors and imported inputs, and price stickiness applies to final goodsprices, then CPI inflation targeting is optimal for an open economy.

5. The cooperative case

I have concentrated on the prescriptions CGG make for an individual economy’smonetary policy when the option of cooperation is not available—the Nashequilibrium case. CGG do find, however, that there are welfare gains available fromcooperation between central banks of different economies. A notable feature of theoptimal cooperative policy is that, in common with the Nash policy, it featuresfloating exchange rates. By contrast, most attempts at cooperation in practice haveinvolved attempts to stabilize exchange rates or to abolish national currencies.Despite this interesting result, there are reasons for believing that CGG’s results forthe Nash equilibrium case are of more relevance to open economies than their resultson cooperation. For one thing, the source of gains from cooperation in CGG’smodel—a higher level of world potential output due to a better global response tocost-push shocks—is questionable, as the empirical importance and interpretation ofcost-push shocks are unresolved issues.6 For another, the feasibility and sustain-ability of cooperation among floating exchange-rate economies (as opposed to eitherconducting an independent monetary policy or adopting a common currency) mightbe questioned. A floating exchange rate has often been advanced, as in Friedman(1953), as a means by which an economy can shield itself from the monetary policymistakes of other economies. Monetary policymakers may conclude that pursuingthe cooperative equilibrium envisaged by CGG entails too great a sacrifice of thisadvantage of floating rates.

6. Conclusion

While I have questioned some aspects of CGG’s model and policy prescriptions,there is no doubting the elegance and tractability of their analysis. CGG havepresented impressive analytical results for optimal monetary policy with a modelthat is considerably richer in its pricing specification than most NOEM models todate. The challenge for future modelling is to retain CGG’s elegance and tractability

6In particular, the interpretation of the cost-push shocks in each country as arising from labor market

rigidity must be weighed against the fact that labor market institutions vary widely across countries.


while attempting to improve our ability to capture inflation dynamics in openeconomies.

References

Aoki, K., 2001. Optimal monetary policy responses to relative-price changes. Journal of Monetary

Economics 48, 55–80.

Auerbach, A.J., Kotlikoff, L.J., 1995. Macroeconomics: An Integrated Approach. South-Western College

Publishing, Cincinatti.

Batini, N., Jackson, B., Nickell, S.J., 2000. Inflation dynamics and the labor share in the UK, External

MPC Unit Discussion Paper no. 2, Bank of England.

Burstein, A., Eichenbaum, M., Rebelo, S., 2002. Why are rates of inflation so low after large

devaluations?, NBER Working Paper no. 8748.

Calvo, G.A., 1983. Staggered prices in a utility-maximizing framework. Journal of Monetary Economics

12, 383–398.

Clarida, R., Gal!ı, J., Gertler, M., 1999. The science of monetary policy: a New Keynesian perspective.

Journal of Economic Literature 37, 1661–1707.

Clarida, R., Gal!ı, J., Gertler, M., 2001. Optimal monetary policy in open versus closed economies: an

integrated approach. American Economic Review (Papers and Proceedings) 91, 248–252.

Clarida, R., Gal!ı, J., Gertler, M., 2002. A simple framework for international monetary policy analysis.

Journal of Monetary Economics 49.

Engel, C., 2002, The responsiveness of consumer prices to exchange rates and the implications for

exchange-rate policy: a survey of a few recent new open-economy macro models, NBER Working

Paper No. 8725.

Friedman, M., 1953. The case for flexible exchange rates. In: Essays in Positive Economics. University of

Chicago Press, Chicago, pp. 157–203.

Gal!ı, J., Gertler, M., 1999. Inflation dynamics: a structural econometric analysis. Journal of Monetary

Economics 44, 195–222.

Gal!ı, J., Monacelli, T., 2000. Optimal monetary policy and exchange rate volatility in a small open

economy, manuscript, Boston College.

King, R.G., Wolman, A.L., 1999. What should the monetary authority do when prices are sticky? In:

Taylor, J.B. (Ed.), Monetary Policy Rules. University of Chicago Press, Chicago, pp. 349–398.

Kollmann, R., 2001. The exchange rate in a dynamic-optimizing business cycle model with nominal

rigidities: a quantitative investigation. Journal of International Economics 55, 243–262.

Lane, P.R., 2001. The new open economy macroeconomics: a survey. Journal of International Economics

54, 235–266.

McCallum, B.T., Nelson, E., 1999. Nominal income targeting in an open-economy optimizing model.

Journal of Monetary Economics 43, 553–578.

Meade, J.E., 1951. The Theory of International Economic Policy, Vol. 1: the Balance of Payments. Oxford

University Press, London.

Monetary Policy Committee, 2001. Inflation Report November 2001. Bank of England, London.

Neiss, K.S., Nelson, E., 2000. The real interest rate gap as an inflation indicator, manuscript, Bank of

England, March, Macroeconomic Dynamics, forthcoming.

Obstfeld, M., Rogoff, K., 1995. Exchange rate dynamics redux. Journal of Political Economy 103, 624–

660.

Svensson, L.E.O., 2000. Open-economy inflation targeting. Journal of International Economics 50, 155–

183.

Wilson, T., 1976. Effective devaluation and inflation. Oxford Economic Papers 28, 1–24.

Woodford, M., 1998. Doing without money: controlling inflation in a post-monetary world. Review of

Economic Dynamics 1, 173–219.

Woodford, M., 2001. Inflation stabilization and welfare. NBER Working Paper No. 8071.


comment on: a simple framework for international monetary policy analysis

Documents