Working Paper: CEPR ID: DP8069
Authors: Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
Abstract: This chapter studies optimal monetary stabilization policy in interdependent open economies, by proposing a unified analytical framework systematizing the existing literature. In the model, the combination of complete exchange-rate pass-through (`producer currency pricing') and frictionless asset markets ensuring efficient risk sharing, results in a form of open-economy `divine coincidence': in line with the prescriptions in the baseline New-Keynesian setting, the optimal monetary policy under cooperation is characterized by exclusively inward-looking targeting rules in domestic output gaps and GDP-deflator inflation. The chapter then examines deviations from this benchmark, when cross-country strategic policy interactions, incomplete exchange-rate pass-through ('local currency pricing') and asset market imperfections are accounted for. Namely, failure to internalize international monetary spillovers results in attempts to manipulate international relative prices to raise national welfare, causing inefficient real exchange rate fluctuations. Local currency pricing and incomplete asset markets (preventing efficient risk sharing) shift the focus of monetary stabilization to redressing domestic as well as external distortions: the targeting rules characterizing the optimal policy are not only in domestic output gaps and inflation, but also in misalignments in the terms of trade and real exchange rates, and cross-country demand imbalances.
Keywords: asset markets; risk-sharing; currency misalignments; demand imbalances; international policy cooperation; optimal targeting rules; pass-through
JEL Codes: E44; E52; E61; F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary policy (E52) | domestic output gaps (E23) |
| monetary policy (E52) | inflation (E31) |
| international monetary spillovers (F30) | national welfare (I39) |
| exchange rate misalignments (F31) | national welfare (I39) |
| optimal monetary policy (E63) | stabilization of domestic output gaps and GDP deflator inflation (E63) |
| deviations from optimal policy (D78) | inefficient real exchange rate fluctuations (F31) |
| misalignments in terms of trade and cross-country demand imbalances (F41) | adjustments for optimal policy (E61) |