Working Paper: CEPR ID: DP2755
Authors: Pierpaolo Benigno
Abstract: This Paper investigates how monetary policy should be conducted in a two-region, general equilibrium model with monopolistic competition and price stickiness. This framework delivers a simple welfare criterion based on the utility of the consumers that has the usual trade-off between stabilizing inflation and output. If the two regions share the same degree of nominal rigidity, the terms of trade are completely insulated from monetary policy and the optimal outcome is obtained by targeting a weighted average of the regional inflation rates. These weights coincide with the economic sizes of the region. If the degrees of rigidity are different, the optimal plan implies a high degree of inertia in the inflation rate. But an inflation targeting policy in which higher weight is given to the inflation in the region with higher degrees of nominal rigidity is nearly optimal.
Keywords: currency area; optimal monetary policy; sticky prices; welfare criterion
JEL Codes: E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| degree of nominal rigidity (D10) | effectiveness of monetary policy (E52) |
| structure of the economy (L16) | optimal monetary policy (E63) |
| price rigidity (D41) | economic distortions (H31) |
| monetary policy decisions (E52) | welfare outcomes (I38) |