Interest Rate Rules, Endogenous Cycles, and Chaotic Dynamics in Open Economies

IMF Working Papers, May 1, 2012

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Canonical URL: Interest Rate Rules, Endogenous Cycles, and Chaotic Dynamics in Open Economies

Paper examines consequences for global equilibrium determinacy in flexible-price open economies from implementing active interest rate rules (nominal interest rate responds more than proportionally to inflation).
Focus on how such rules can generate aggregate instability by inducing liquidity traps, endogenous cycles, and chaotic dynamics.
Key finding: Rules that respond to expected future inflation are more prone to induce endogenous cyclical and chaotic dynamics the more open the economy is to trade.
Authors: Luis-Felipe Zanna, Marco Airaudo.
Date: May 1, 2012.
Series: IMF Working Papers, Working Paper No. 2012/121.

Active interest rate rules can generate multiple forms of aggregate instability:
- Liquidity traps.
- Endogenous cycles.
- Chaotic dynamics.
The incidence and nature of these instabilities depend on specific characteristics of open economies.
Sensitivity to openness:
- Rules that respond to expected future inflation exhibit greater propensity to induce endogenous cyclical and chaotic dynamics as trade openness increases.
Emphasis on forward-looking policy response (response to expected future inflation) as a source of complex dynamics in open-economy settings.

Design of monetary policy rules in open economies should account for trade openness and the potential for forward-looking policy responses to create instability.
Caution warranted when implementing active interest rate rules that place strong weight on expected future inflation in small open economies or economies with high trade openness.
Recognition that standard prescriptions from closed-economy analyses may not carry over straightforwardly to open economies due to differing stability properties.

Subject: Consumption, Exchange rate pass-through, Foreign exchange, Import prices, Inflation, National accounts, Prices, Real exchange rates.
Keywords: Chaos, closed economy, Consumption, Cycles and Endogenous Fluctuations, exchange rate pass-through, Exchange rate pass-through, Global, Import prices, Inflation, interest rate, interest rate rule, Interest Rate Rules, liquidity trap, marginal utility, money balance, Multiple Equilibria, Real exchange rates, Small Open Economy, Taylor Rules, WP.