of capital (from the investment condition (18)) which leads to an increase in expected
future marginal cost and thus an additional rise in expected future inflation. Therefore
indeterminacy is generated if the effect of this cost channel of monetary policy is suffi-
ciently strong to counteract the downward pressure on inflation arising from the aggregate
demand channel. In the open-economy the increase in expected future marginal cost is
exacerbated as the degree of trade openness increases. This strengthens the effect of the
cost channel making a rise in domestic price inflation more likely. From (38) there are
two opposing effects on CPI inflation, the strength of both are increasing as the degree
of trade openness increases (a ^). Therefore depending on the size of a this determines
which effect dominates and thus whether the initial inflationary belief is validated.
4 The Timing of Interest-rate Rules
So far the analysis has focused on interest-rate rules that target contemporaneous infla-
tion. In this section we consider interest-rate rules that react to either forward-looking or
backward-looking inflation.
4.1 Forward-looking rules
We start by examining the conditions for equilibrium determinacy under forward-looking
inflation rules. The aggregate and difference systems are both four-dimensional generating
a zero eigenvalue in each case. Since capital is the only predetermined variable, equilibrium
determinacy requires the remaining three eigenvalues to lie outside the unit circle. This
automatically suggests that for determinacy of the difference system, the root associated
with the capital stock dynamics must be unstable, which in turn implies that determinacy
is impossible for sufficiently open economies.
4.1.1 Aggregate System
Under a forward-looking rule, the set of linearized equations for the world aggregates,
given in Table 1, yields a system of the form:
20