DP78 | Alternative Financial Policy Rules in an Open Economy Under Rational and Adaptive Expectations

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The potential instability of a fixed monetary rule combined with automatic fixed stabilisers is a well-established feature of closed economy IS/LM models with wealth effects and asset accumulation. This paper examines the stability issue in a general open economy macromodel with alternative expectations mechanisms (rational or adaptive) in both the labour market and the foreign exchange market. The fixed monetary rule is found to be stabilising only in special cases, notably when post-tax real interest rates are negative and the foreign exchange market is characterised by high capital mobility and rational expectations. By contrast, the alternative rule of fixing the rate of growth of nominal government debt is stable for a wide range of parameter values and alternative expectations schemes.