Working Paper: NBER ID: w14829
Authors: Charles Engel
Abstract: This paper examines optimal monetary policy in an open-economy two-country model with sticky prices. We show that currency misalignments are inefficient and lower world welfare. We find that optimal policy must target not only inflation and the output gap, but also the currency misalignment. However the interest rate reaction function that supports this targeting rule may involve only the CPI inflation rate. This result illustrates how examination of "instrument rules" may hide important trade-offs facing policymakers that are incorporated in "targeting rules". The model is a modified version of Clarida, Gali, and Gertler's (JME, 2002). The key change is that we allow pricing to market or local-currency pricing and consider the policy implications of currency misalignments. Besides highlighting the importance of the currency misalignment, our model also gives a rationale for targeting CPI, rather than PPI, inflation.
Keywords: currency misalignments; monetary policy; open economy; 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 |
|---|---|
| currency misalignments (F31) | inefficient allocations (D61) |
| currency misalignments (F31) | world welfare (I30) |
| targeting currency misalignments (F31) | inflation and output goals (E31) |
| currency misalignments (F31) | CPI inflation (E31) |
| currency misalignments (F31) | output gap (E23) |
| inefficient allocations (D61) | world welfare (I30) |