Working Paper: CEPR ID: DP3349
Authors: Giancarlo Corsetti; Paolo Pesenti
Abstract: This Paper provides a baseline general-equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities. An inward-looking policy of complete domestic output stabilization is not optimal when firms' markups are exposed to currency fluctuations. Such policy raises exchange rate volatility, leading foreign exporters to charge higher prices vis-a-vis the increased uncertainty in the export market. As higher import prices reduce the purchasing power of domestic consumers, optimal monetary rules trade off a larger domestic output gap against lower consumer prices. Optimal rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a non-monotonic way to the degree of exchange rate pass-through.
Keywords: Exchange rate pass-through; International cooperation; Nominal rigidities; Optimal cyclical monetary policy
JEL Codes: E31; E52; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic monetary policy (E52) | Exchange rate volatility (F31) |
| Exchange rate volatility (F31) | Domestic consumers' purchasing power (D12) |
| Exchange rate volatility (F31) | Foreign firms' pricing strategies (L11) |
| Discretionary policies (E60) | Overstabilization of the domestic economy (E63) |
| Overstabilization of the domestic economy (E63) | Welfare (I38) |
| Optimal monetary policies (E63) | Exchange rate volatility (F31) |
| Optimal monetary policies (E63) | Domestic output stabilization (E23) |
| Exchange rate pass-through (F31) | Welfare outcomes (I38) |