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Optimal monetary policy in open economies

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  • 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

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8069.

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Date of creation: Oct 2010
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Handle: RePEc:cpr:ceprdp:8069

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Related research

Keywords: Asset markets and risk sharing; Currency misalignments; Demand Imbalances; International Policy Cooperation; Optimal targeting Rules; Pass-through;

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References

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  1. Bianca De Paoli, 2004. "Monetary Policy and Welfare in a Small Open Economy," CEP Discussion Papers dp0639, Centre for Economic Performance, LSE.
  2. Vasco Cúrdia & Michael Woodford, 2008. "Credit frictions and optimal monetary policy," Working Paper Research 146, National Bank of Belgium.
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  4. Devereux, Michael B & Shi, Kang & Xu, Juanyi, 2004. "Global Monetary Policy Under a Dollar Standard," CEPR Discussion Papers 4317, C.E.P.R. Discussion Papers.
  5. 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.
  6. Emi Nakamura & Dawit Zerom, 2009. "Accounting for Incomplete Pass-Through," NBER Working Papers 15255, National Bureau of Economic Research, Inc.
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  10. 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.
  11. Smets, Frank & Wouters, Raf, 2002. "Openness, imperfect exchange rate pass-through and monetary policy," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 947-981, July.
  12. Giancarlo Corsetti & Paolo Pesenti, 2002. "Self-validating optimum currency areas," Staff Reports 152, Federal Reserve Bank of New York.
  13. Pierpaolo Benigno & Michael Woodford, 2008. "Linear-Quadratic Approximation of Optimal Policy Problems," Discussion Papers 0809-01, Columbia University, Department of Economics.
  14. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
  15. Pinelopi Koujianou Goldberg & Rebecca Hellerstein, 2008. "A Framework for Identifying the Sources of Local-Currency Price Stability with an Empirical Application," Working Papers 1161, Princeton University, Department of Economics, Center for Economic Policy Studies..
  16. Pierpaolo Benigno, 2008. "Price stability with imperfect financial integration," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  17. Günter Coenen & Giovanni Lombardo & Frank Smets & Roland Straub, 2007. "International Transmission and Monetary Policy Cooperation," NBER Chapters, in: International Dimensions of Monetary Policy, pages 157-192 National Bureau of Economic Research, Inc.
  18. 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.
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  20. Pedro Teles & Bernardino Adao & Isabel Correia, 2005. "Exchange Rate Regimes," 2005 Meeting Papers 382, Society for Economic Dynamics.
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Citations

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Cited by:
  1. Chan Wang & Heng-fu Zou, 2012. "On the efficiency of monetary and fiscal policy in open economies," CEMA Working Papers 534, China Economics and Management Academy, Central University of Finance and Economics.
  2. 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.
  3. 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.
  4. Michael Woodford, 2010. "Optimal Monetary Stabilization Policy," Discussion Papers 0910-18, Columbia University, Department of Economics.
  5. 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.
  6. Alessandro Flamini, 2012. "Interest Rate Forecasts in Inflation Targeting Open-Economies," DEM Working Papers Series 027, University of Pavia, Department of Economics and Management.
  7. 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.
  8. Lombardo, Giovanni & Ravenna, Federico, 2014. "Openness and optimal monetary policy," Journal of International Economics, Elsevier, vol. 93(1), pages 153-172.
  9. repec:ksb:journl:v:4:y:2011:i:1:p:32-47 is not listed on IDEAS
  10. 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.
  11. 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.
  12. Giovanni Lombardo & Federico Ravenna, 2014. "Openness and Optimal Monetary Policy," Cahiers de recherche 1410, CIRPEE.

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