On discretion versus commitment and the role of the direct exchange rate channel in a forward-looking open economy model

Irrespective of whether discretion or commitment to a binding rule guides the conduct of monetary policy, the existence of a direct exchange rate channel in the Phillips Curve causes the behavior of the key economic variables in the open economy to be dramatically different from that in the closed economy. In the open economy, the policymaker can no longer perfectly stabilize real output and the rate of inflation in the face of IS and UIP shocks as well as shocks to foreign inflation. If the exchange rate channel in the Phillips Curve is operative, then in the open economy the policymaker faces an output-inflation tradeoff that differs substantially from its counterpart in the closed economy. ; Our analysis of the conduct of monetary policy reveals that the stabilization bias under discretion is weaker in the open economy relative to the closed economy. In the open economy, a less conservative central banker, one that attaches a smaller weight to the variance of inflation in the loss function, can be appointed to replicate the behavior of real output that eventuates under optimal policy. Evaluating the social loss function under discretion and commitment, we find that the existence of a direct exchange rate channel in the Phillips Curve mitigates the pronounced differences between the two strategies that exist in case of high persistence in the stochastic shocks.