Working Paper: CEPR ID: DP2854
Authors: Pierpaolo Benigno
Abstract: This Paper evaluates the welfare implications of policy rules when international financial markets are incomplete. Using a two-country dynamic general equilibrium model with incomplete markets, price stickiness and monopolistic competition, one finds that an allocation in which the producer inflation rates in both countries are stabilized to zero reproduces the flexible-price allocation. This allocation, however, is sub-optimal with deadweight losses evaluated at around 0.05 percent of a permanent shift in steady-state consumption. A state-contingent producer inflation policy is the feasible first-best. The gains from pursuing this policy instead of price stability are, however, small in terms of reduction in the deadweight losses. Therefore, under incomplete markets, price stability is a good approximation of the feasible first best policy.
Keywords: incomplete markets; optimal monetary policy; price stability
JEL Codes: E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stabilizing producer inflation rates to zero (E31) | reproduces the same allocation as under flexible prices (D51) |
| stabilizing producer inflation rates to zero (E31) | does not achieve the first-best outcome under incomplete markets (D52) |
| zero-inflation targeting policy (E31) | deadweight losses from following a zero-inflation targeting policy (E31) |
| optimal policy should involve state-contingent producer inflation rates (E31) | economic efficiency (D61) |
| price stability (E31) | does not fully account for the complexities introduced by market incompleteness (D52) |