Working Paper: CEPR ID: DP4386
Authors: Ester Faia; Tommaso Monacelli
Abstract: We analyse welfare-maximizing monetary policy in a dynamic general equilibrium two-country model with price stickiness and imperfect competition. In this context, a typical terms of trade externality affects policy interaction between independent monetary authorities. Unlike the existing literature, we remain consistent to a public finance approach by an explicit consideration of all the distortions that are relevant to the Ramsey planner. This strategy entails two main advantages. First, it allows an accurate characterization of optimal policy in an economy that evolves around a steady state that is not necessarily efficient. Second, it allows us to describe a full range of alternative dynamic equilibria when price-setters in both countries are completely forward-looking and households? preferences are not restricted. We study optimal policy both in the long run and in response to shocks, and we compare commitment under Nash competition and under cooperation. By deriving a second order accurate solution to the policy functions, we also characterize the welfare gains from international policy cooperation.
Keywords: Cooperation; Imperfect Competition; Nash Equilibrium; Optimal Monetary Policy; Ramsey Planner; Sticky Prices
JEL Codes: E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Policy competition in an international setting (L13) | Independent policymakers deviate from price stability (E61) |
| Nash competition (C72) | Manipulation of price levels to enhance relative prices (F16) |
| Manipulation of price levels to enhance relative prices (F16) | Increase in real net income and consumption (E21) |
| Centralized approach by a world Ramsey planner (H00) | Outcomes that replicate those of a flexible price economy (D50) |
| International policy cooperation (F55) | Welfare gains (D69) |