Model Persistence and the Role of the Exchange Rate and Instrument Inertia in Monetary Policy. Rodrigo Caputo

This paper addresses two of the unsettled issues in the design of monetary policy in small open economies: the importance of the exchange rate and the interpretation of the observed inertia in the policy interest rate. In doing so, this paper derives an optimizing macroeconomic model that introduces habit formation in the consumer’s utility function and inertia in the inflation equation. As a consequence, aggregate demand and supply shocks will have a persistent effect on output and inflation. In this framework, we assess the performance of monetary policy rules under different degrees of habit formation and inflation inertia. We conclude that an inflation based rule, containing also a response to output and the exchange rate, is optimal. This rule performs particularly well in the presence of some domestic and foreign shocks. When less persistence is introduced in the economy, that rule is still the optimal one. Finally, the gains of adopting an inertial policy rule are directly related to the degree of inflation persistence in the model. 1