Interest rate rules and equilibrium (in)determinacy in a small open economy: the role of internationally traded capital

Abstract

Abstract This study develops a small-open-economy version of Benhabib, J., S. Schmitt-Grohé, and M. Uribe. 2001. “Monetary Policy and Multiple Equilibria.” American Economic Review 91: 167–186. We systematically explore the role of international capital mobility and the portfolio balance channel in terms of macroeconomic (in)stability when the government follows a commonly-adopted interest-rate feedback rule. In a one-traded-good model, the steady-state equilibrium, in general, is locally determinate; international capital mobility stabilizes the economy against business cycle fluctuations under a simple interest-rate feedback rule. In a two-good (traded and non-traded goods) model, the relationship between equilibrium (in)determinacy and the aggressiveness of interest rate rules is not monotonic, and crucially depends on households’ portfolio preferences. These results suggest that a unified interest rate rule can end up with very different consequences of macroeconomic (in)stability in an open economy from those in a closed economy.