Time Consistency and Counterproductive Monetary Policy Cooperation in a Two‐Country New Keynesian Model

Abstract

We use a two-country New Keynesian model to revisit the issue of counterproductive monetary policy cooperation. By analyzing the optimal commitment, discretionary, and sustainable policies, we show how counterproductive cooperation and governments' commitment ability are linked. The global Friedman rule, whereby both countries always adopt the Friedman rule, maximizes the joint welfare for a wide range of parameters. However, cooperation makes the global Friedman rule unimplementable under discretionary policies and harder to sustain under sustainable policies. Counterproductive cooperation therefore arises naturally when governments lack commitment ability and some stronger commitment device than reputation is necessary to achieve gains from cooperation.