Expectations, monetary policy rules, and macroeconomic stability. Analysis of an open economy with flexible exchange rates

Abstract

This paper makes use of a dynamic model of an open economy with flexible exchange rates to examine the dynamic characteristics of the system for different specifications of monetary authority behavior. The model contains dynamic adjustment equations for both output and prices. Two policy rules are examined: (a) maintaining a constant nominal money supply growth, and (b) maintaining a constant nominal interest rate. With the former the system is found to be self-equilibrating. The latter, however, could easily give rise to self-perpetuating disequilibrium situations. In both cases expectations play a crucial role in the adjustment process. © 1981.