Optimal Monetary Policy in Open Economies

92 Pages Posted: 22 Nov 2010

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

Date Written: October 2010

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 and risk sharing, Currency misalignments, Demand Imbalances, International Policy Cooperation, Optimal targeting Rules, Pass-through

JEL Classification: E44, E52, E61, F41, F42

Suggested Citation

Corsetti, Giancarlo and Dedola, Luca and Leduc, Sylvain, Optimal Monetary Policy in Open Economies (October 2010). CEPR Discussion Paper No. DP8069, Available at SSRN: https://ssrn.com/abstract=1711082

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Luca Dedola

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
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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