Working Paper: CEPR ID: DP440
Authors: Daniel Cohen; Charles Wyplosz
Abstract: We analyze a two-country zone facing a joint inflationary shock and responding with coordinated and uncoordinated monetary and fiscal policies. We show that the standard presumption that the absence of coordination results in an excessive exchange rate appreciation of the zone with respect to the rest of the world hinges on a specific assumption: that within the two countries considered, the price effect of exchange rate fluctuations dominates the trade effects relatively to the corresponding effects vis-a-vis the rest of the world. If the relative hierarchy goes the other way around (as we argue is likely for EC countries), the standard conclusion is reversed, resulting in insufficiently active monetary and fiscal policies. The paper considers asymmetric shocks as well as monetary policy coordination.
Keywords: policy coordination; exchange rates
JEL Codes: 310; 430
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate fluctuations (F31) | domestic prices (P22) |
| exchange rate fluctuations (F31) | trade balances (F10) |
| absence of coordination (P11) | excessive exchange rate appreciation (F31) |
| price effect dominates trade effect (F14) | excessive exchange rate appreciation (F31) |
| policymakers appreciate currency to export inflation (F31) | contractionary policies (E65) |
| trade effect dominates (F14) | insufficient monetary and fiscal responses (E63) |
| asymmetric shocks (F41) | exacerbated trade imbalances (F69) |
| uncoordinated responses (P11) | excessive policy actions in negatively affected country (F65) |
| coordinated monetary policy (E61) | mitigated adverse effects of uncoordinated fiscal policies (F42) |