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International Dimensions of Optimal Monetary Policy

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Author Info
Giancarlo Corsetti
Paolo Pesenti

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Abstract

This paper provides a baseline general-equilibrium model of optimal monetary policy among interdependent economies, with monopolistic firms that set prices one period in advance. Strict adherence to inward-looking policy objectives such as the stabilization of domestic output cannot be optimal when firms' markups are exposed to currency fluctuations. Such policies induce excessive volatility in exchange rates and foreign sales revenue, leading exporters to set higher prices in response to higher profit risk. In general, optimal rules trade off a larger domestic output gap against lower import prices. Monetary rules in a world Nash equilibrium lead to smaller exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a non-monotonic way to the degree of exchange rate pass-through.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8230.

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Date of creation: Apr 2001
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Handle: RePEc:nbr:nberwo:8230

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Find related papers by JEL classification:
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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References listed on IDEAS
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  5. Eric Parrado & Andres Velasco, 2002. "Optimal Interest Rate Policy in a Small Open Economy," NBER Working Papers 8721, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Benigno, Gianluca & Benigno, Pierpaolo, 2001. "Price Stability as a Nash Equilibrium in Monetary Open-Economy Models," CEPR Discussion Papers 2757, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  18. Taylor, John B., 2000. "Low inflation, pass-through, and the pricing power of firms," European Economic Review, Elsevier, vol. 44(7), pages 1389-1408, June. [Downloadable!] (restricted)
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  21. Philippe Bacchetta & Eric van Wincoop, 2000. "Does Exchange-Rate Stability Increase Trade and Welfare?," American Economic Review, American Economic Association, vol. 90(5), pages 1093-1109, December. [Downloadable!] (restricted)
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  22. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper 01-02, Federal Reserve Bank of Richmond. [Downloadable!]
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  23. Fabio Ghironi & Alessandro Rebucci, 2000. "Monetary Rules for Emerging Market Economies," Boston College Working Papers in Economics 476, Boston College Department of Economics, revised 13 Aug 2001. [Downloadable!]
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  24. Raf Wouters & Frank Smets, 2000. "Optimal Monetary Policy In An Open Economy," Computing in Economics and Finance 2000 186, Society for Computational Economics.
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  26. Jordi Gali, 1999. "Technology, Employment, and the Business Cycle: Do Technology Shocks Explain Aggregate Fluctuations?," American Economic Review, American Economic Association, vol. 89(1), pages 249-271, March. [Downloadable!] (restricted)
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  27. Maurice Obstfeld & Kenneth Rogoff, 2000. "Do We Really Need a New International Monetary Compact?," NBER Working Papers 7864, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  29. Pinelopi Koujianou Goldberg & Michael M. Knetter, 1997. "Goods Prices and Exchange Rates: What Have We Learned?," Journal of Economic Literature, American Economic Association, vol. 35(3), pages 1243-1272, September. [Downloadable!] (restricted)
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  30. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999. [Downloadable!]
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  32. Lane, Philip R., 1997. "Inflation in open economies," Journal of International Economics, Elsevier, vol. 42(3-4), pages 327-347, May. [Downloadable!] (restricted)
  33. Cedric Tille, 1999. "The role of consumption substitutability in the international transmission of shocks," Staff Reports 67, Federal Reserve Bank of New York. [Downloadable!]
  34. Romer, David, 1993. "Openness and Inflation: Theory and Evidence," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 869-903, November. [Downloadable!] (restricted)
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  35. Maurice Obstfeld, 2001. "International Macroeconomics: Beyond the Mundell-Fleming Model," NBER Working Papers 8369, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  36. Cavallari, Lilia, 2001. "Inflation and Openness with Non-Atomistic Wage Setters," Scottish Journal of Political Economy, Scottish Economic Society, vol. 48(2), pages 210-25, May. [Downloadable!] (restricted)
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