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Gains from Coordination in a Multi-Sector Open Economy: Does it Pay to be Different?

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Zheng Liu
Evi Pappa

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Abstract

Do countries gain by coordinating their monetary policies if they have different economic structures? We address this issue in the context of a new open-economy macro model with a traded and a non-traded sector and more importantly, with a across-country asymmetry in the size of the traded sector. We study optimal monetary policy under independent and cooperating central banks, based on analytical expressions for welfare objectives derived from quadratic approximations to individual preferences. In the presence of asymmetric structures, a new source of gains from coordination emerges due to a terms-of-trade externality. This externality affects unfavorably the country that is more exposed to trade and its effects tend to be overlooked when national central banks act independently. The welfare gains from coordination are sizable and increase with the degree of asymmetry across countries and the degree of openness, and decrease with the within-country correlation of sectoral shocks.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 296.

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