Working Paper: CEPR ID: DP3436
Authors: Thomas F. Cooley; Vincenzo Quadrini
Abstract: We study the optimal monetary policy in a two-country open-economy model under two monetary arrangements: (a) multiple currencies controlled by independent policy-makers; (b) common currencies controlled by a centralized policy-maker. Our findings suggest that: (i) Monetary policy competition leads to higher long-term inflation and interest rates with large welfare losses; (ii) The inflation bias and the consequent losses are larger when countries are unable to commit to future policies; (iii) in both cases, the welfare losses from higher in ation dominates the welfare costs of losing the ability to react optimally to business cycle shocks. Therefore, the coordination of policies implicit in the adoption of a common currency or dollarization has positive welfare consequences.
Keywords: common currency; international coordination; optimal monetary policy
JEL Codes: E00; E50; F00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy competition (E49) | Systematic inflation bias (E31) |
| Systematic inflation bias (E31) | Higher inflation and interest rates (E31) |
| Higher inflation and interest rates (E31) | Welfare losses (D69) |
| Lack of commitment (J22) | Increased inflation bias (E31) |
| Adoption of common currency (F36) | Elimination of inflation bias (E31) |
| Elimination of inflation bias (E31) | Positive welfare consequences (I31) |