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Policy Cooperation, Incomplete Markets, and Risk Sharing

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  • Charles Engel

Abstract

The paper derives “targeting rules” for optimal policy in a simple two-country model in which financial markets are incomplete and policy is noncooperative. The optimal rules are compared with the cooperative case. Although the model is simple, it is complex enough so that the distortion introduced by incomplete financial markets matters. The complete markets case serves as a benchmark. Under complete markets, it is shown that the policy response in one state of the world influences outcomes in all other states through the effect on asset prices. It is noted that monetary policy cannot replicate an optimal tariff, so that the absence of a tariff instrument is a distortion even in the complete-markets economy. We show that optimal policy, even under complete markets and cooperation, does not try to minimize spillovers.

Suggested Citation

  • Charles Engel, 2016. "Policy Cooperation, Incomplete Markets, and Risk Sharing," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(1), pages 103-133, May.
    • Handle: RePEc:pal:imfecr:v:64:y:2016:i:1:p:103-133
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    Cited by:

    1. Pierre‐Richard Agénor & Timothy Jackson & Enisse Kharroubi & Leonardo Gambacorta & Giovanni Lombardo & Luiz A. Pereira Da Silva, 2021. "Assessing the Gains from International Macroprudential Policy Cooperation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(7), pages 1819-1866, October.
    2. Fujiwara, Ippei & Wang, Jiao, 2017. "Optimal monetary policy in open economies revisited," Journal of International Economics, Elsevier, vol. 108(C), pages 300-314.
    3. Liutang Gong & Jianjian Liu & Chan Wang & Liyuan Wu & Heng-fu Zou, 2020. "International trade in intermediate inputs and the welfare gains from monetary policy cooperation," CEMA Working Papers 610, China Economics and Management Academy, Central University of Finance and Economics.
    4. Corsetti, G. & Lipińska, A. & Lombardo, G., 2021. "Sharing Asymmetric Tail Risk Smoothing, Asset Pricing and Terms of Trade," Cambridge Working Papers in Economics 2153, Faculty of Economics, University of Cambridge.
    5. Wei, Shang-Jin & Xie, Yinxi, 2020. "Monetary policy in an era of global supply chains," Journal of International Economics, Elsevier, vol. 124(C).
    6. Giancarlo Corsetti & Anna Lipinska & Giovanni Lombardo, 2021. "Sharing Asymmetric Tail Risk: Smoothing, Asset Prices and Terms of Trade," International Finance Discussion Papers 1324, Board of Governors of the Federal Reserve System (U.S.).
    7. Xia, Tian, 2020. "The role of intermediate goods in international monetary cooperation," Journal of International Money and Finance, Elsevier, vol. 100(C).

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