International transmission of shocks, money illusion and the velocity of money
AbstractMoney illusion is frequently invoked and frequently resisted by economists. Resisted as it contradicts the maximizing paradigm of microeconomic theory and invoked since a tendency to think in nominal rather than real terms becomes evident in the behavior of agents. This paper rationalizes money illusion in an stylized open economy model considering that private agents learn nominal aggregate demand at a level different from the one imposed by rationality. We find that the welfare effects of a productivity shock are increasing in the degree of money illusion and decreasing in the degree of openness of the economy. Furthermore we introduce a velocity of money shock revisiting the Quantity Theory of Money within the open economy micro-founded framework. An incomplete information game between Home and Foreign policymakers with monetary policy rules is developed, where sudden unstable financial conditions arise in one country, to find that allowing for velocity shocks reinforces the need for optimal monetary policy rules and to open the economies in order to avoid welfare costs. --
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Bibliographic InfoPaper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number 2011-49.
Date of creation: 2011
Date of revision:
Optimal monetary policy; open economy; international transmission mechanism; money illusion; velocity of money; nominal rigidities;
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
- F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-12-19 (All new papers)
- NEP-CBA-2011-12-19 (Central Banking)
- NEP-MAC-2011-12-19 (Macroeconomics)
- NEP-MON-2011-12-19 (Monetary Economics)
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