Staff Reports

International Dimensions of Optimal Monetary Policy

April 2001Number 124
JEL classification: E31, E52, F42

Authors: Giancarlo Corsetti and Paolo Pesenti

This paper provides a baseline general-equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms that set prices one period in advance. Strict adherence to inward-looking policy objectives such as the stabilization of domestic output cannot be optimal when firms' markups are exposed to currency fluctuations. Such policies induce excessive volatility in exchange rates and foreign sales revenue, leading exporters to set higher prices in response to higher profit risk. In general, optimal rules trade off a larger domestic output gap against lower import prices. Monetary rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in an nonmonotonic way to the degree of exchange rate pass-through.

Available only in PDFPDF45 pages / 280 kb

For a published version of this report, see Giancarlo Corsetti and Paolo Pesenti, "International Dimensions of Optimal Monetary Policy," Journal of Monetary Economics 52, no. 2 (March 2005):
281-305.