This paper studies the conditions under which price stability is the optimal policy in a two-country open-economy model with imperfect competition and price stickiness. Special conditions on the levels of country-specific distortionary taxation and the intratemporal and intertemporal elasticities of substitution need to be satisfied. These restrictions apply to both cooperative and non-cooperative settings. Most importantly, we show that cooperative and non-cooperative solutions do not coincide despite market completeness and producer currency pricing. In this framework, our analysis suggests a role for international policy coordination. IntroductionThere is a large consensus among policymakers and students of monetary policy that price stability should be the main objective of a Central Bank. This is a desirable goal insofar as it can induce an efficient allocation of resources across different uses and times. An increasing literature on monetary policy evaluation has started to address the issue of optimal monetary policy in stochastic general-equilibrium models with monopolistic competition and price stickiness. * This is a revised version of our working paper Benigno and Benigno (2001a). We are indebted to Michael Woodford for helpful and detailed comments. We thank also Peter Andrews, Jinill Kim, Paolo Pesenti and Simon Price. We thank three anonymous referees for helpful comments. All errors are our own.

This study analyzes a two-country dynamic general equilibrium model with nominal rigidities, monopolistic competition and producer currency pricing. A quadratic approximation to the utility of the consumers is derived and assumed as the policy objective function of the policymakers. It is shown that only under special conditions there are no gains from cooperation and moreover that the paths of the exchange rate and prices in the constrained-efficient solution depend on the kind of disturbance that affects the economy. It might be the case either for fixed or floating exchange rates. Despite this result, simple targeting rules that involve only targets for the growth of output and for both domestic GDP and CPI inflation rates can replicate the cooperative allocation.

No abstract

This paper addresses the consumption-real exchange rate anomaly. International real business cycle models based on complete financial markets predict a unitary correlation between the real exchange rate and the ratio of home to foreign consumption when subjected to supply side shocks. In the data, this correlation is usually small and often negative. This paper shows that this anomaly can be successfully addressed by models that have an incomplete financial market structure and a non-traded as well as traded goods production sector.JEL Classification: F31, F41