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Optimal inflation in an open economy with imperfect competition

  • David M. Arseneau

This paper uses a two-country, monetary general equilibrium model with imperfect competition to study the optimal rate of inflation in an open economy. In contrast with the closed economy literature, when policy is set non-cooperatively in the open economy, the optimality of the Friedman rule is not a general result. Monetary authorities face an incentive to use the inflation tax to gain a "beggar-thy-neighbor" advantage over the terms of trade. Strategic use of the inflation tax, however, results in coordination failure. International monetary cooperation helps to mitigate this coordination failure and, as a result, can lead to more efficient equilibria. Monetary union ensures the maximum gain from cooperation by restoring the optimality of the global Friedman rule, placing the world economy at the Pareto frontier.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-25.

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Date of creation: 2004
Date of revision:
Handle: RePEc:fip:fedgfe:2004-25
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  1. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," NBER Working Papers 7665, National Bureau of Economic Research, Inc.
  2. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
  3. Russell Cooper & Hubert Kempf, 2003. "Commitment and the Adoption of a Common Currency," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 119-142, February.
  4. David Bowman & Brian M. Doyle, 2003. "New Keynesian, open-economy models and their implications for monetary policy," International Finance Discussion Papers 762, Board of Governors of the Federal Reserve System (U.S.).
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  6. Chari, V. V. & Christiano, Lawrence J. & Kehoe, Patrick J., 1996. "Optimality of the Friedman rule in economies with distorting taxes," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 203-223, April.
  7. Kimbrough, Kent P., 1993. "Optimal monetary policies and policy interdependence in the world economy," Journal of International Money and Finance, Elsevier, vol. 12(3), pages 227-248, June.
  8. Philippe BACCHETTA & Eric VAN WINCOOP, 1999. "Does Exchange Rate Stability Increase Trade and Welfare ?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9917, Université de Lausanne, Faculté des HEC, DEEP.
  9. Thomas F. Cooley & Vincenzo Quadrini, 2003. "Common Currencies vs. Monetary Independence," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 785-806, October.
  10. Kimbrough, Kent P., 1991. "Optimal taxation and inflation in an open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(1), pages 179-196.
  11. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2003. "Optimal Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 825-860, October.
  12. Lane, Philip R., 1999. "The New Open Economy Macroeconomics: a Survey," CEPR Discussion Papers 2115, C.E.P.R. Discussion Papers.
  13. Ireland, Peter N., 1997. "Sustainable monetary policies," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 87-108, November.
  14. Matthew B. Canzoneri & Robert E. Cumby & Behzad T. Diba, 2002. "The Need for International Policy Coordination: What's Old, What's New, What's Yet to Come?," NBER Working Papers 8765, National Bureau of Economic Research, Inc.
  15. Alexander L. Wolman, 2001. "A primer on optimal monetary policy with staggered price-setting," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 27-52.
  16. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September.
  17. repec:oup:qjecon:v:116:y:2001:i:2:p:421-445 is not listed on IDEAS
  18. Isabel Correia & Pedro Teles, 1997. "The optimal inflation tax," Discussion Paper / Institute for Empirical Macroeconomics 123, Federal Reserve Bank of Minneapolis.
  19. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 743-764, October.
  20. Benigno, Pierpaolo, 2002. "A simple approach to international monetary policy coordination," Journal of International Economics, Elsevier, vol. 57(1), pages 177-196, June.
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