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Optimal Monetary Policy in Open Economies

In: Handbook of Monetary Economics

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Author Info

  • Corsetti, Giancarlo
  • Dedola, Luca
  • Leduc, Sylvain

Abstract

This chapter studies optimal monetary stabilization policy in interdependent open economies, by proposing a unified analytical framework systematizing the existing literature. In the model, the combination of complete exchange-rate pass-through ('producer currency pricing') and frictionless asset markets ensuring efficient risk sharing, results in a form of open-economy 'divine coincidence': in line with the prescriptions in the baseline New-Keynesian setting, the optimal monetary policy under cooperation is characterized by exclusively inward-looking targeting rules in domestic output gaps and GDP-deflator inflation. The chapter then examines deviations from this benchmark, when cross-country strategic policy interactions, incomplete exchange-rate pass-through ('local currency pricing') and asset market imperfections are accounted for. Namely, failure to internalize international monetary spillovers results in attempts to manipulate international relative prices to raise national welfare, causing inefficient real exchange rate fluctuations. Local currency pricing and incomplete asset markets (preventing efficient risk sharing) shift the focus of monetary stabilization to redressing domestic as well as external distortions: the targeting rules characterizing the optimal policy are not only in domestic output gaps and inflation, but also in misalignments in the terms of trade and real exchange rates, and cross-country demand imbalances.

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Bibliographic Info

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This chapter was published in:

  • Benjamin M. Friedman & Michael Woodford (ed.), 2010. "Handbook of Monetary Economics," Handbook of Monetary Economics, Elsevier, edition 1, volume 3, number 3, January.
    This item is provided by Elsevier in its series Handbook of Monetary Economics with number 3-16.

    Handle: RePEc:eee:monchp:3-16

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    Web page: http://www.elsevier.com/wps/find/bookseriesdescription.cws_home/BS_HE/description

    Related research

    Keywords: Currency Misalignments; Demand Imbalances; Pass-Through; Asset Markets and Risk Sharing; Optimal Targeting Rules; International Policy Cooperation;

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    References

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    1. Coenen, Günter & Lombardo, Giovanni & Smets, Frank & Straub, Roland, 2008. "International transmission and monetary policy cooperation," Working Paper Series 0858, European Central Bank.
    2. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
    3. Pierpaolo Benigno & Michael Woodford, 2006. "Linear-Quadratic Approximation of Optimal Policy Problems," NBER Working Papers 12672, National Bureau of Economic Research, Inc.
    4. Bianca De Paoli, 2009. "Monetary Policy under Alternative Asset Market Structures: The Case of a Small Open Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(7), pages 1301-1330, October.
    5. Benigno, Pierpaolo, 2001. "Price Stability with Imperfect Financial Integration," CEPR Discussion Papers 2854, C.E.P.R. Discussion Papers.
    6. Gianluca Benigno & Pierpaolo Benigno, 2004. "Designing target rules for international monetary policy cooperation," LSE Research Online Documents on Economics 3759, London School of Economics and Political Science, LSE Library.
    7. Alan C. Stockman & Linda L. Tesar, 1995. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," NBER Working Papers 3566, National Bureau of Economic Research, Inc.
    8. Devereux, Michael B. & Shi, Kang & Xu, Juanyi, 2007. "Global monetary policy under a dollar standard," Journal of International Economics, Elsevier, vol. 71(1), pages 113-132, March.
    9. Sven W. Arndt & J. David Richardson, 1988. "Real-Financial Linkages Among Open Economies," NBER Working Papers 2230, National Bureau of Economic Research, Inc.
    10. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
    11. Pedro Teles & Bernardino Adao & Isabel Correia, 2005. "Exchange Rate Regimes," 2005 Meeting Papers 382, Society for Economic Dynamics.
    12. Morten O. Ravn & Stephanie Schmitt-Grohe & Martin Uribe, 2006. "Pricing to Habits and the Law of One Price," Economics Working Papers ECO2006/40, European University Institute.
    13. Singh, Rajesh & Lahiri, Amartya & Vegh, Carlos A, 2007. "Segmented Asset Markets and Optimal Exchange Rate Regimes," Staff General Research Papers 11446, Iowa State University, Department of Economics.
    14. Pinelopi Koujianou Goldberg & Rebecca Hellerstein, 2006. "A Framework for Identifying the Sources of Local-Currency Price Stability with an Empirical Application," 2006 Meeting Papers 625, Society for Economic Dynamics.
    15. Helpman, Elhanan & Razin, Assaf, 1978. "A theory of international trade under uncertainty," MPRA Paper 22112, University Library of Munich, Germany.
    16. Vasco Curdia & Michael Woodford, 2008. "Credit Frictions and Optimal Monetary Policy," Discussion Papers 0809-02, Columbia University, Department of Economics.
    17. Bianca De Paoli, 2004. "Monetary Policy and Welfare in a Small Open Economy," CEP Discussion Papers dp0639, Centre for Economic Performance, LSE.
    18. Pappa, Evi, 2004. "Do the ECB and the fed really need to cooperate? Optimal monetary policy in a two-country world," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 753-779, May.
    19. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
    20. Emi Nakamura & Dawit Zerom, 2009. "Accounting for Incomplete Pass-Through," NBER Working Papers 15255, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Michael Woodford, 2010. "Optimal Monetary Stabilization Policy," Discussion Papers 0910-18, Columbia University, Department of Economics.
    2. Flamini Alessandro, 2012. "Interest Rate Forecasts in Inflation Targeting Open-Economies," Economia politica, Società editrice il Mulino, issue 3, pages 381-408.
    3. Rhee, Hyuk Jae & Song, Jeongseok, 2013. "Real wage rigidities and optimal monetary policy in a small open economy," Journal of Macroeconomics, Elsevier, vol. 37(C), pages 110-127.
    4. Chan Wang & Heng-fu Zou, 2013. "On the efficiency of monetary and fiscal policy in open economies," Annals of Economics and Finance, Society for AEF, vol. 14(1), pages 179-206, May.
    5. repec:ksb:journl:v:4:y:2011:i:1:p:32-47 is not listed on IDEAS
    6. Masashige Hamano & Pierre M. Picard, 2013. "Extensive and intensive margins and the choice of exchange rate regimes," CREA Discussion Paper Series 13-18, Center for Research in Economic Analysis, University of Luxembourg.
    7. Teo, Wing Leong, 2011. "Inventories and optimal monetary policy in a small open economy," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1719-1748.
    8. Giancarlo Corsetti & Gernot J. Müller, 2011. "Multilateral Economic Cooperation and the International Transmission of Fiscal Policy," NBER Working Papers 17708, National Bureau of Economic Research, Inc.
    9. Piotr Banbula & Witold Kozinski & Michal Rubaszek, 2011. "The role of the exchange rate in monetary policy in Poland," BIS Papers chapters, in: Bank for International Settlements (ed.), Capital flows, commodity price movements and foreign exchange intervention, volume 57, pages 285-295 Bank for International Settlements.
    10. Haradhan Kumar Mohajan, 2011. "The NNP and Sustainability in Open Economy: Highlights on Recent World Economy and on Open Economy of Bangladesh," KASBIT Journal of Management & Social Science, Khadim Ali Shah Bukhari Institute of Technology (KASBIT), vol. 4, pages 32-47, December.
    11. Giovanni Lombardo & Federico Ravenna, 2014. "Openness and Optimal Monetary Policy," Cahiers de recherche 1410, CIRPEE.

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