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International transmission of shocks, money illusion and the velocity of money

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  • Sousa, Teresa
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    Abstract

    Money 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 Info

    Paper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number 2011-49.

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    Date of creation: 2011
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    Handle: RePEc:zbw:ifwedp:201149

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    Keywords: Optimal monetary policy; open economy; international transmission mechanism; money illusion; velocity of money; nominal rigidities;

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    1. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," Working Papers 042000, Hong Kong Institute for Monetary Research.
    2. Corsetti, Giancarlo, 2006. "Openness and the Case for Flexible Exchange Rates," CEPR Discussion Papers 5612, C.E.P.R. Discussion Papers.
    3. Giancarlo Corsetti & Paolo Pesenti, 1997. "Welfare and Macroeconomic Interdependence," NBER Working Papers 6307, National Bureau of Economic Research, Inc.
    4. Obstfeld, Maurice & Duarte, Margarida, 2005. "Monetary Policy in the Open Economy Revisited: The Case for Exchange-Rate Flexibility Restored," 2005 Meeting Papers 386, Society for Economic Dynamics.
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