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Optimal Monetary Policy in an Interdependent World

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  • Michael Evers

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Abstract

In the literature on international monetary policy, the paradigm is that gains from coordination are fairly small. Monetary policy is conducted to stabilize macroeconomic fluctuations and gains from policy coordination arise from preventing national monetary authorities from strategically manipulating the terms of trade by means of these stabilization policy instruments. However, as it has been emphasized by \cite{lucas:2003a}, welfare gains from stabilizing fluctuations are generically small since they are of second order. In this paper, I develop a dynamic stochastic two-country model with sticky wages and a cash-in-advance restriction which is in the spirit of the New Open Economy Macroeconomics framework. In this environment, monetary authorities can manipulate the terms of trade by conducting a general short-run monetary policy using both the nominal interest rate and the money supply. The money supply affects the terms of trade by altering the nominal exchange rate ex post and it is used in the traditional way so as to stabilize macroeconomic fluctuations. The nominal interest rate affects the terms of trade by changing expected inflation ex ante. Self-oriented national policymakers use the nominal interest rates to raise the terms of trade ex ante. This leads to an inefficient inflation tax whose welfare effects are of first order. Consequently, gains from monetary policy coordination are of first order.

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Bibliographic Info

Paper provided by University of Bonn, Germany in its series Bonn Econ Discussion Papers with number bgse10_2007.

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Length: 25
Date of creation: Jul 2007
Date of revision:
Handle: RePEc:bon:bonedp:bgse10_2007

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Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
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Web page: http://www.bgse.uni-bonn.de

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Keywords: International Policy Coordination; General Short-Run Monetary Policy; New Open Economy Macroeconomics;

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Cited by:
  1. Michael P. Evers, 2007. "Optimum Policy Domains in an Interdependent World," Bonn Econ Discussion Papers bgse12_2007, University of Bonn, Germany.

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