Investment and Interest Rate Policy in the Open Economy

The above analysis suggests that in the presence of capital there are important im-
plications for equilibrium determinacy depending on whether the economy is open or
closed. In a closed-economy, indeterminacy can easily be prevented by avoiding forward-
looking interest-rate rules. However in open-economies implementing current-looking or
backward-looking policies is contingent upon the degree of trade openness of the econ-
omy in question. For sufficiently closed economies, the monetary authority should adopt
a current-looking CPI interest-rate rule to minimize policy-induced aggregate instabil-
ity. However for economies that are sufficiently open to trade a backward-looking CPI
interest-rate rule is a more appropriate policy.

5 Conclusion

This paper has considered the importance of trade openness for equilibrium determinacy
in the presence of capital and investment spending. It has been shown that policy in-
duced indeterminacy is considerably easier to obtain using a sticky-price open-economy
model compared to its closed-economy variant. This conclusion is robust to the index of
inflation chosen as the policy indicator and the timing of the interest-rate rule employed.
The analysis suggests that considerable care needs to be taken when designing interest-
rate rules for economies that actively engage in cross-country trade. Adopting policies
advocated for closed-economies, may not be sufficient to prevent the emergence of real
indeterminacy.

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