Following from Woodford's (2003) derivation of a benevolent monetary policy maker's objective function from agents utility, some papers have suggested that policy in an open economy should have the same objectives as in a closed economy, and in particular that the exchange rate should play no role. The robustness of this isomorphism claim is examined in Kirsanova,Leith and Wren-Lewis (2006). In particular, we look at a model in which there are shocks to International Risk Sharing or Uncovered Interest Parity. Exchange rate volatility generated by such shocks has often been a key element in arguments suggesting that policy should be concerned about exchange rate movements.
Our results suggest that in general the presence of such shocks does introduce a role for the terms of trade gap into the benevolent policy maker's objective function, so isomorphism does not hold. The exception is the special case when agents' utility from consumption is logarithmic, which is the assumption in Gali and Monacelli (2005). We suggest that the terms of trade gap has similarities to deviations from Williamson's Fundamental Equilibrium Exchange Rate or FEER.
An alternative rationalisation for terms related to the exchange rate appearing in the social welfare function is provided in Leith and Wren-Lewis(2006). This looks at a model with traded and non-traded goods. It shows that in general welfare will depend on output and inflation in both sectors, but an objective function involving only aggregate variables can be derived if this function also includes measures related to the exchange rate.
The possibility that a benevolent policy maker's desire to raise output above the natural rate might cause steady state inflation to be above target when expectations are rational (inflation bias) has been central to debates on macroeconomic policy, and in particular the desirability of independent central banks. While the seminal model (Barro and Gordon, 1983) is static, the analysis has been extended to dynamic Phillips curves (Clarida, Gali and Gertler, 1999, for example). In Kirsanova, Vines and Wren-Lewis (2009), we generalise this literature by looking at NAIRU Phillips curves which contain a combination of forward and backward looking elements, and New Keynesian Phillips curves where policy makers discount at a different rate from the private sector.
We show that negative inflation bias will occur under a commitment or timeless perspective policy, with either a hybrid NAIRU Phillips curve which is mainly forward looking, or with a New Keynesian Phillips curve if policy makers discount at a higher rate than the private sector.
In Kirsanova, Vines and Wren-Lewis (2007), two examples are considered where the extent of inflation persistence (where current inflation depends on past inflation as well as expected future inflation) is crucial for macroeconomic outcomes.
The 'Credit Crunch' of 2007-9 showed the limitations of monetary policy, the re-emergence of counter-cyclical fiscal policy, and the importance of policy towards government debt. In Wren-Lewis (2010) I examine these issues, and also the responsibility of macroeconomic policy for the credit crunch itself. This paper summarises a number of themes dealt with in more detail elsewhere. It was also written during the initial stages of the recession, when it was still possible to be optimistic about governments’ ability and willingness to close the output gap. However, 2010 saw a shift from (limited) fiscal stimulus to austerity. Wren-Lewis (2011) explores the reasons behind this shift. It argues that although problems with debt can explain this policy change in some (Euro area) countries, the explanation elsewhere owes a great deal to ideological factors.
References
Barro, R., and D. Gordon (1983): “Rules, Discretion and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics, 12, 101-121.
Clarida, R. H., J. Galí, and M. Gertler (1999): The Science of Monetary Policy: A New Keynesian Perspective, Journal of Economic Literature, 37, 1661-1707.
Gali, J. and Monacelli, T. (2005). Monetary policy and exchange rate volatility in a small open economy,Review of Economic Studies, 75, 707-34.
Kirsanova, T, Leith, C and Wren-Lewis, S (2006) Should Monetary Policy Target Consumer Price Inflation or the Exchange Rate, Economic Journal, 116, F208-231 (article, earlier version)
Leith, C. and Wren-Lewis, S. (2006) The Optimal Monetary Policy Response to Exchange Rate Misallignments (working paper)
Woodford, Michael (2003) Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton University Press.