When to Align and When to Contract: Technology Shocks, Optimal Policies, and Exchange Rate Regimes

This paper characterizes optimal monetary policy responses to technology shocks in a two-country model with sticky prices, local currency pricing, and international technology diffusion. We show that technology shocks originating in the tradable sector, regardless of their country of origin, elicit symmetric and closely coordinated monetary policy responses across countries, providing a rationale for a fixed exchange rate regime. By contrast, technology shocks originating in the nontradable sector generate asymmetric policy responses and depreciate the source country's currency, supporting the case for exchange rate flexibility. We further show that the international transmission of technology shocks amplifies real sector dynamics through news effects, prompting central banks to adopt contractionary policies, a result that stands in sharp contrast to the prior literature.