Monetary Policy in a Low Pass-Through Environment

50 Pages Posted: 28 Apr 2003

See all articles by Tommaso Monacelli

Tommaso Monacelli

Bocconi University - Department of Economics

Date Written: April 2003

Abstract

We study the effects on the optimal monetary policy design problem of allowing for deviations from the law of one price in import goods prices. We reach three basic results. First, we show that incomplete pass-through renders the analysis of monetary policy of an open economy fundamentally different from the one of a closed economy, unlike canonical model with perfect pass-through which emphasize a type of isomorphism. Second, and in response to efficient productivity shocks, incomplete pass-through has the effect of generating endogenously a short-run tradeoff between the stabilization of inflation and of the output gap. This holds independently of the measure of inflation being targeted by the monetary authority. Third, in studying the optimal program under commitment relative to discretion, we show that the former entails a smoothing of the deviations from the law of one price, in stark contrast with the established empirical evidence. In addition, an optimal commitment policy always requires, relative to discretion, more stable nominal and real exchange rates.

Keywords: deviations from the law of one price, policy trade-off, gains from commitment, exchange rate channel

JEL Classification: E52, E32, F41

Suggested Citation

Monacelli, Tommaso, Monetary Policy in a Low Pass-Through Environment (April 2003). IGIER Working Paper No. 228; ECB Working Paper No. 227. Available at SSRN: https://ssrn.com/abstract=376740

Tommaso Monacelli (Contact Author)

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

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