Should Exchange Rates be Ignored in the Setting of Monetary Policy?

The aim of this paper is to highlight the role of parameter uncertainty in optimal open-economy monetary policy. Parameter uncertainty is introduced by assuming that the coefficients of the model are random, but with known stochastic properties. The results indicate that the Taylor rule is a reasonable approximation to optimal monetary policy under uncertainty, even in an open economy. The intuition behind the result is the "Brainard conservatism principle", which drives the respone coefficients of the exchange rate variables in the optimal rule close to zero, while the response coefficients on inflation and output are similar to values suggested by Taylor. The model is estimated on German data and the Taylor rule is found to be roughly similar to the optimal rule under uncertainty.