December 2005

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

Marco Airaudo and Luis-Felipe Zanna


In this paper we present an extensive analysis of the consequences for global equilibrium determinacy of implementing active interest rate rules (i.e. monetary rules where the nominal interest rate responds more than proportionally to changes in inflation) in flexible-price open economies. We show that conditions under which these rules generate aggregate instability by inducing cyclical and chaotic equilibrium dynamics depend on particular characteristics of open economies such as the degree of (trade) openness and the degree of exchange rate pass-through implied by the presence of non-traded distribution costs. For instance, we find that a forward-looking rule is more prone to induce endogenous cyclical and chaotic dynamics the more open the economy and the higher the degree of exchange rate pass-through. The existence of these dynamics and their dependence on the degree of openness are in general robust to different timings of the rule (forward-looking versus contemporaneous rules), to the use of alternative measures of inflation in the rule (CPI versus Core inflation), as well as to changes in the timing of real money balances in liquidity services ("cash-when-I-am-done" timing versus "cash-in-advance" timing).

Full paper (screen reader version)

Keywords: Small open economy, interest rate rules, multiple equilibria, chaos, endogenous fluctuations

PDF: Full Paper

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