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Ramsey Monetary Policy and International Relative Prices

  • Ester Faia
  • Tommaso Monacelli

We analyze welfare maximizing monetary policy in a dynamic general equilibrium two-country model with price stickiness and imperfect competition. In this context, a typcial terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in a economy that evolves around a steady state which is not necessarily efficient. Second, it allows to describe a full range of alternative dynamic equilibria when price setters in both countries are completely forward-looking and households' preferences are not restricted. We study optimal policy both in the long-run and in response to shocks, and we compare commitment under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 254.

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Date of creation: 2004
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Handle: RePEc:igi:igierp:254
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