spending, the degree of trade openness increases the prominence of aggregate instability
with the violation of the Taylor principle. This is robust not only to the index of inflation
targeted, but also to the timing of the interest-rate rule employed. The failure of the Tay-
lor principle for open-economies therefore suggests that monetary authorities face much
greater challenges in the design of interest-rate rules. Specifically, in a sense to be made
precise below, we argue that in order to minimize aggregate instability sufficiently open
economies should react to backward-looking consumer price inflation, whereas sufficiently
closed-economies should target current-looking consumer price inflation.
The remainder of the paper is organized as follows. Section 2 develops the two-
country model. Section 3 examines the conditions for real equilibrium determinacy when
current-looking interest-rate rules are employed. Section 4 considers the implications of
alternative interest rate rules that react to forward-looking or backward-looking inflation.
Finally Section 5 concludes.
2 The Model
Consider a global economy that consists of two countries denoted home and foreign, where
an asterisk denotes foreign variables. Within each country there exists a representative
infinitely-lived agent, a representative final good producer, a continuum of intermediate
good producing firms, and a monetary authority. The representative agent owns all do-
mestic intermediate good producing firms and supplies labor and capital to the production
process. Intermediate firms operate under monopolistic competition and use domestic la-
bor and capital as inputs to produce tradeable goods which are sold to the home and
foreign final good producers. The labor and rental capital markets are both assumed
to be competitive. Each representative final good producer is a competitive firm that
bundles domestic and imported intermediate goods into non-tradeable final goods, which
are consumed by the domestic agent. Preferences and technologies are symmetric across
the two countries. The following presents the features of the model for the home country
on the understanding that the foreign case can be analogously derived.