indexes, which can be chosen as the policy indicator, are considered: domestic price in-
flation and consumer price inflation. By allowing for trade openness, it is shown that
the indeterminacy problem is more severe under a forward-looking interest-rate rule and
gets increasingly worse as the degree of openness increases. This result is robust for both
possible indexes of inflation that can enter the feedback rule. However, unlike closed-
economy models, this indeterminacy problem can no longer be dramatically reduced by
adopting an active current-looking rule. For both indexes of inflation, indeterminacy is
induced provided the degree of trade openness is sufficiently high.
The intuition behind these results rests with how the degree of trade openness ex-
acerbates the cost-channel of monetary policy which arises in sticky-price models with
capital. As discussed by Kurozumi and Van Zandweghe (2007) for a closed-economy,
under an active policy an increase in the real interest rate puts upward pressure on the
expected future rental price of capital, which raises expected marginal cost. Consequently
indeterminacy can arise if the upward pressure on inflation generated through this cost
channel outweighs the downward pressure on inflation generated through the standard
aggregate demand channel of monetary policy. Allowing for trade openness increases the
effect of the aggregate demand channel on the dynamics of inflation. This arises since an
active policy stance results in a improvement in the terms of trade, thereby generating
additional downward pressure on marginal cost. However trade openness also raises ex-
pected marginal cost as a future expected deterioration in the terms of trade is anticipated.
Consequently if the degree of trade openness is sufficiently large then this cost channel
strictly dominates the demand channel and inflation expectations become self-fulfilling.
This paper contributes to the growing body of literature that focuses on the real inde-
terminacy implications of designing interest-rate rules in the presence of trade openness. A
general conclusion arising from the existing literature is that the degree of trade openness
is only important for aggregate stability if monetary policy responds to expected future
consumer price inflation. Reacting to expected future domestic price inflation or imple-
menting a current-looking rule guarantees equilibrium determinacy if the Taylor principle
is adhered to.5 Our analysis suggests that with the addition of capital and investment
5See, for example, Zanna (2002), De Fiore and Liu (2005), Batini et al. (2004), Llosa and Tuesta (2006),
Linnemann and Schabert (2002, 2006) and McKnight (2007).