Comments on ‘’Monetary policy rules in open economies with traded and non-traded goods’’ by B. Doyle, C. Erceg and A. Le

1. Comments on ‘’Monetary policy rules in open economies with traded and non-traded goods’’ by B. Doyle, C. Erceg and A. Levin Ester Faia Universitat Pompeu Fabra Conference on ‘’Quantitative Evaluation of Stabilization Policies’’ September 2005

2. The plan of the paper • VAR evidence: monetary policy shock (Choleski decomposition) has differential effects on traded and non-traded sector • Two-Country large scale model with: monopolistic competition in product and labour market, sticky prices, sticky wages, quadratic adjustment cost on the change of import shares, financial intermediation cost on foreign bonds, adjustment cost on investment, habit persistence in consumption, adjustment cost on capital. • Impulse response to UIP shocks, government expenditure shocks and TFP shocks (in traded sector) • To be done: welfare evaluation (perturbation methods), full commitment policy (Ramsey cooperative regime?)

3. Results • Targeting CPE inflation → large deviations in sectoral output from potential. • Reacting to exchange rate and/or wage inflation → large deviations in sectoral output from potential. • Main mechanism: • Traded sector is more sensitive to exchange rate and interest rate changes • A rule targeting an index sensitive to exchange rate fluctuations amplifies deviations from potential levels under sticky prices

4. Matching between data and model I • Discrepancy between the shock identified in the VAR and the ones used to do the numerical exercise. • Shocks calibration: direct estimation is better than indirect calibration: 1. Shock to risk premium → welfare is sensitive to autocorrelation (Kollman (2002)) • Shock to government spending: see Perotti (2004) • Productivity shock in traded sector: VAR estimates with long run restrictions

5. Matching between the data and the model II • Sticky prices and wages do not seem to amplify non-synchronous responses of traded and non-traded sector relatively to the flexible price allocation • Clarify the role of sticky prices/wages in matching the data • Better to use models which are also consistent with major stylized facts in open economy (six major puzzles)

6. Welfare and monetary policy rules • Potential levels are not necessarily the benchmark for a monetary rule • Even when closing both gaps (sticky prices and sticky wages) there are still many triangles →compare to potential output • The monetary authority might use sticky prices and wages to improve upon the flexible price allocation → (see Adao, Correia and Teles (2002), Goodfriend and King (2000) for open economy) • To see whether zero inflation is optimal →find conditions for which optimal mark-up is constant (Benigno and Benigno (2002)) • Open economy →zero inflation not optimal; (deflationary bias in Corsetti and Pesenti (2002) inflationary bias in Cooley and Quadrini (2000))

7. Principles of optimal policy • This economy features two gaps (due to sticky prices and sticky wages) and six triangles 1. Monopolistic competition in product market → wedge on the condition linking the MRS between labor and consumption and the MRT. 2. Monopolistic competition in labor market → wedge on the MRT in intermediate good sector. 3. Adjustment costs on capital → inter-temporal wedge on the consumption Euler 4. Risk premium on foreign bonds → time-varying on the inter-temporal choice of consumption 5. Adjustment cost on the change of import shares → wedge on the condition linking the MRS between domestic and foreign produced goods and the MRT 6. Adjustment cost on the change of import shares for traded sector → same as above

8. Optimal policy I – The linear quadratic • Fiscal authority provides a series of subsidies to offset all wedges, monetary authority closes the gaps with a rule targeting both CPE and wage inflation • Welfare criterion would be a micro-founded loss function a’ la Woodford (provided it can be derived with capital and independently for the two countries) • Monetary policy would be a truly stabilization tool. Optimal policy delivers an operational rule (Tinbergen approach) • Second order conditions can be easily checked

9. Optimal policy II – perturbation methods • Optimality is conditional to the type of rules adopted • With so many wedges and a single instrument would be impossible to interpret the results • Compare the dynamic behavior of inflation and output with and without the wedges (potential levels) and determine the nature of the monetary policy trade-offs

10. Optimal policy III – Ramsey commitment policy • Lucas and Stockey (1983), Chari and Kehoe (1990) • Khan, King and Wolman (2000)→shut-off one distortion at the time to understand the principles • Avoid numerical black box • Check second order conditions or saddle point conditions • Not possible to get ‘’operational’’ rule

11. Comparative advantage of policy makers • Can the monetary policy take care of all distortions with a single instruments? • Fiscal policy has implementation delays and credibility problems • We need a theory of comparative advantage of policy maker

12. Solving time zero Ramsey • Timeless perspective (Woodford and McCallum) versus recursive contract approach (Marcet and Marimon (2000)) • Models with capital→ linear methods do not capture welfare costs of transitional dynamics • Solving the time zero game in Nash competition

13. Warning! Determinacy. • Indeterminacy of the price levels and money supply in sticky price models → (Carlstrom and Fuerst (1997), Ireland (2000), Adao, Correia and Teles (2002)) • Open economy two country (coordination case) →one instrument (money supply) and two path for prices to pin down (domestic and foreign)

14. Nash competition • Nash competition in the dual → each policymakertake as given policy instrument of the other country (Chari and Kehoe (1990) for fiscal policy competition, Corsetti and Pesenti (2002) for monetary policy competition with money supply instrument (determined residually from the real allocation) • Nash competition in the primal → Faia and Monacelli (2003) take as given foreign consumption (but only reaction function) • Closed loop versus open loop → only the first is sub game perfect equilibrium

15. Market incompleteness • Market incompleteness for bonds → closed economy implies volatile inflation and constant taxes (Lucas and Stockey (1983)). • Would that imply volatile exchange rates in open economy? • Opening up the economy might help to complete markets (Schmitt-Grohe and Uribe (2000))

16. What index shall we target in open economy? • Clarida, Gali’ and Gertler (2000) and Gali’ and Monacelli (2002) → optimality implies target of domestic inflation • Corsetti and Pesenti (2003) → inward looking policy not optimal when firms’ markups are exposed to currency fluctuations • Svensson (2000)→ all inflation targeting countries have chosen to target CPI inflation • Bernanke and Mishkin (1997) → Australia, Canada, Finland, Israel, New Zeland, Sweden, UK adopted CPI inflation targeting • Campolmi (2005) → under sticky wages and CPI indexation it is optimal to target an average of CPI and wage inflation

17. Minor comments • Clarify the role of money • Why adjustment costs on import shares → better to microfound imperfect pass-through (Monacelli (2002), Corsetti and Dedola (2002))

18. Conclusions • A theory of comparative advantage of policy makers • Game theory perspective of optimal policy → sustainable plans, self confirming equilibrium • Ramsey plans under uncertainty