The timeless perspective vs. discretion: Theory and monetary policy implications for an open economy

Compared to the standard Phillips curve, an open-economy version that features a real exchange rate channel leads to a markedly different target rule in a New Keynesian optimizing framework. Under optimal policy from a timeless perspective (TP) the target rule involves additional history dependence in the form of lagged inflation. The target rule also depends on more parameters, notably the discount factor as well as two IS and two Phillips curve parameters. Stabilization policy in this open economy model is no longer isomorphic to policy in a closed economy. Because of the additional history dependence in an open economy target rule, price level targeting is no longer consistent with optimal policy. The gains from commitment are smaller in economies where the real exchange rate channel exerts a direct effect on inflation in the Phillips curve.

► The real exchange rate in the Phillips curve alters the target rule under commitment.
► It now depends on two IS and two Phillips curve parameters and the discount factor.
► Lagged inflation also appears in the rule.
► Discretionary price level targeting is no longer consistent with optimal policy.