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Optimal inflation in an open economy with imperfect competition

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Author Info
David M. Arseneau

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Abstract

This paper uses a two-country, monetary general equilibrium model with imperfect competition to study the optimal rate of inflation in an open economy. In contrast with the closed economy literature, when policy is set non-cooperatively in the open economy, the optimality of the Friedman rule is not a general result. Monetary authorities face an incentive to use the inflation tax to gain a "beggar-thy-neighbor" advantage over the terms of trade. Strategic use of the inflation tax, however, results in coordination failure. International monetary cooperation helps to mitigate this coordination failure and, as a result, can lead to more efficient equilibria. Monetary union ensures the maximum gain from cooperation by restoring the optimality of the global Friedman rule, placing the world economy at the Pareto frontier.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-25.

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Date of creation: 2004
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Handle: RePEc:fip:fedgfe:2004-25

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Related research
Keywords: Monetary policy ; Inflation (Finance);

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References listed on IDEAS
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  2. Kimbrough, Kent P., 1991. "Optimal taxation and inflation in an open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(1), pages 179-196. [Downloadable!] (restricted)
  3. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August. [Downloadable!] (restricted)
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  5. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2000. "Optimal monetary policy," Working Paper 00-10, Federal Reserve Bank of Richmond. [Downloadable!]
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  6. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Blackwell Publishing, vol. 70(4), pages 743-764, October. [Downloadable!] (restricted)
  7. Ireland, Peter N., 1997. "Sustainable monetary policies," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 87-108, November. [Downloadable!] (restricted)
  8. Charles Carlstrom & Timothy Fuerst, 2000. "Optimal Monetary Policy in a Small Open Economy: A General Equilibrium Analysis," Working Papers Central Bank of Chile 70, Central Bank of Chile. [Downloadable!]
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  9. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimality of the Friedman Rule in Economies with Distorting Taxes," NBER Working Papers 4443, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "The Need for International Policy Coordination: What's Old, What's New, What's Yet to Come?," NBER Working Papers 8765, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," NBER Working Papers 7665, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Russell Cooper & Hubert Kempf, 2003. "Commitment and the Adoption of a Common Currency," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 119-142, February. [Downloadable!] (restricted)
  13. Benigno, Pierpaolo, 2002. "A simple approach to international monetary policy coordination," Journal of International Economics, Elsevier, vol. 57(1), pages 177-196, June. [Downloadable!] (restricted)
  14. Thomas F. Cooley & Vincenzo Quadrini, 2003. "Common Currencies vs. Monetary Independence," Review of Economic Studies, Blackwell Publishing, vol. 70(4), pages 785-806, October. [Downloadable!] (restricted)
  15. David Bowman & Brian M. Doyle, 2003. "New Keynesian, open-economy models and their implications for monetary policy," International Finance Discussion Papers 762, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  18. Kimbrough, Kent P., 1993. "Optimal monetary policies and policy interdependence in the world economy," Journal of International Money and Finance, Elsevier, vol. 12(3), pages 227-248, June. [Downloadable!] (restricted)
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  1. Gianluca Benigno & Bianca De Paoli, 2009. "On the International Dimension of Fiscal Policy," CEP Discussion Papers dp0905, Centre for Economic Performance, LSE. [Downloadable!]
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  2. Cengiz, Gulfer & Cicek, Deniz & Kuzubas, Tolga Umut & Olcay, Nadide Banu & Saglam, Ismail, 2007. "A Monetary Union Model with Cash-in-Advance Constraints," MPRA Paper 4248, University Library of Munich, Germany. [Downloadable!]
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