The Role of Openness in the Debate on Rules vs. Discretion: A Simple Exposition

In this paper, we examine to what extent the degree of openness matters for the conduct of monetary policy. Our findings suggest that the stabilising properties of nominal income and price level targeting often reported in the literature on monetary policy in closed economies do not carry over to an economy that imports an intermediate input. We also show that the inverse link between openness and average inflation reported by Romer (1993) obtains under discretion. Finally, we compare and contrast discretion to the various rule-based strategies of monetary policy using policy frontiers. In all but one comparison greater openness makes discretion more attractive relative to the rule-based strategies of monetary policy. Nevertheless, in light of empirical estimates for the size of the variances of demand and supply shocks, the case for rule-based monetary policy strategies cannot be dismissed. Rule-based strategies perform better against discretion in the face of supply disturbances rather than demand disturbances.