Optimal Monetary Policy and the Sources of Local-Currency Price Stability

59 Pages Posted: 5 Jun 2008

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Luca Dedola

Bank of Italy; European Central Bank (ECB)

Sylvain Leduc

Federal Reserve Banks - Federal Reserve Bank of San Francisco

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Abstract

We analyze the policy trade-offs generated by local currency price stability of imports in economies where upstream producers strategically interact with downstream firms selling the final goods to consumers. We study the effects of staggered price setting at the downstream level on the optimal price (and markup) chosen by upstream producers and show that downstream price movements affect the desired markup of upstream producers, magnifying their price response to shocks. We revisit the international dimensions of optimal monetary policy, unveiling an argument in favour of consumer price stability as the main prescription for monetary policy. Since stable consumer prices feed back into a low volatility of markups among upstream producers, this contains inefficient deviations from the law of one price at the border. However, efficient stabilization of different CPI components will not generally result into perfect stabilization of headline inflation. National policies optimally respond to the same shocks in a similar way, thus containing volatility of the terms of trade, but not necessarily of the real exchange rate. The latter will be more volatile, among other things, the larger the home bias in expenditure and the content of local inputs in consumer goods.

Keywords: exchange rate pass-through, optimal monetary policy, price discrimination, price dispersion, real exchange rates

JEL Classification: F31, F33, F41

Suggested Citation

Corsetti, Giancarlo and Dedola, Luca and Leduc, Sylvain, Optimal Monetary Policy and the Sources of Local-Currency Price Stability. CEPR Discussion Paper No. DP6557. Available at SSRN: https://ssrn.com/abstract=1140084

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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Luca Dedola

Bank of Italy ( email )

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Rome, 00184
Italy

European Central Bank (ECB) ( email )

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Frankfurt am Main, 60314
Germany

Sylvain Leduc

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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