Investment and Interest Rate Policy in the Open Economy

1-a

1

1      1.5     2     2.5     3     3.5     4     4.5     5

μ

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

Figure 2: Regions of determinacy under a current-looking consumer price inflation rule

the inclusion of capital generates substantial differences for equilibrium determinacy not
only between closed and open-economies, but also between the index of inflation targeted.
What is the economic intuition behind these results? First consider a labor-only economy.
Suppose that in response to a non-fundamental shock agents believe (CPI) inflation will
increase. In a closed-economy an active monetary policy (μ > 1) increases the real interest
rate. From the aggregate demand channel of monetary policy this reduces (real) marginal
cost such that current inflation rises by less than expected inflation via the Phillips curve.
In an open economy the CPI inflation rate depends on both the domestic inflation rate
and the terms of trade:

^πt = ^πh + (1 ^- a) (Tt ^- Tt-1)                        ⁽³⁸⁾

where Γ_t-1 is predetermined. An increase in the real interest rate not only reduces do-
mestic inflation via a fall in marginal cost but in addition results in an improvement in
the terms of trade (Γ_t ^). From (38) this trade channel of monetary policy generates
additional downward pressure on CPI inflation. Consequently for both closed and open-
economies the initial belief cannot be self-fulfilling. Now consider an economy with capital
accumulation. Here the initial increase in inflationary expectations can be self-fulfilling
provided that there is a further rise in expected inflation. This can occur since an in-
crease in the real interest rate puts upward pressure on the expected future rental price

19

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