Macroeconomic Interdependence in a Two-Country DSGE Model under Diverging Interest-Rate Rules

The present article extends a variant of the Obstfeld/Rogoff (2001) two-country DSGE model by introducing Calvo (1983) pricing. It is possible to collapse the model into a canonical log-linear representation consisting of two dynamic IS and two New Keynesian Phillips curves. Reflecting the differing statutes of the ECB and the Fed, two diverging interest-rate rules are introduced. For a sensible calibration of the model we can derive a locally unique rational expectations equilibrium. Furthermore, we find that aggregate productivity shocks, which are assumed to be positively correlated across countries, have a negative impact on domestic and foreign output, a phenomenon already described for the closed economy by Galí (2002). Cost-push as well as contractionary monetary policy shocks, which are assumed to be country-specific, also have a negative impact on domestic and foreign output since the economies are interdependent due to terms-of-trade externalities. Contrary to Corsetti/Pesenti (2001), expansionary monetary policy shocks always have a "prosper thyself" and "beggar thy neighbor" effect since they influence the terms of trade beneficially for the respective country's resident households. Finally, if the ECB implemented the interest-rate rule proposed in the present article, it would encounter lower fluctuations in European producer price inflation compared to an interest-rate rule as proposed for the Fed. This is consistent with the ECB's paramount objective of price stability. However, this advantage only holds at the expense of relatively high fluctuations in the European output gap.