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. 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.
The previous quotation outlines the basic idea behind the literature on international monetary policy cooperation in the 1980s and 1990s. The existence of externalities, whether positive or negative, is the source of a need of international monetary cooperation when countries do not internalize the effects of their actions on other countries.
In this study, we depart from the previous literature, discussed among others in Canzoneri and Gray (1985), Canzoneri and Henderson (1991), and Persson and Tabellini (1995), by considering a two-country model in which both the structure of the economy and the welfare criteria of the policymakers are derived from microfoundations. We revisit the scope for international monetary policy cooperation in a world in which goods and capital markets are perfectly integrated and where the disturbances that affect the economies originate from productivity, public expenditure and mark-up shocks.
We are not the first to address this issue in a microfounded model.2 However, our contribution to the literature is to use a linear-quadratic solution method, as discussed in Benigno and Woodford (2005), to allow a direct comparison of the objective functions of the policymakers and the structure of the economies with the ones that were assumed in the previous literature. In a two-country open-economy model, we derive a quadratic utility-based objective function for each policymaker. As a difference with respect to the aforementioned literature, these objectives are not only quadratic in domestic output gap and producer inflation but contain other targets for the terms-of-trade, foreign output gap and producer inflation.
We analyze the cooperative and non-cooperative allocation. First, our analysis shows that it is not possible to give a conclusive prescription on which exchange-rate regime can enforce cooperation except for saying that it should be contingent on the kind of disturbance that hits the economies. As in Devereux and Engel (2003) and Obstfeld and Rogoff (2002), the exchange rate should float in order to accommodate asymmetric productivity shocks mirroring Friedman's prescription for flexible exchange rates.3 Monetary policymakers are then left with the role of pursuing the domestic goal of price stability. On the opposite, when the economy is hit by other shocks, as mark-up disturbances, the optimal cooperative outcome might imply a stable exchange rate. Prices and outputs should move to accommodate the shock. Second, our model suggests that in general there are gains from cooperation.4 The driving force steams from the same terms-of-trade externality that was central in the previous literature. However, the existence of gains from cooperation depends on the interaction between the terms-of-trade externality and the model's distortions in terms of rigidity of prices and monopoly power in the goods market.
At a first sight, these results would suggest that the task of designing institutions that can implement the cooperative solution is a difficult one, since it would require to specify some control of the exchange rate conditional on the type of disturbance that occurs. Despite this initial premise, we show that it is still possible to design simple monetary institutions that can implement the optimal cooperative outcome. We appeal to the concept of targeting rules proposed by Svensson, 2002, Svensson, 2003 and Svensson, 2004, as implemented by Giannoni and Woodford (2002). Our targeting rules involve only a combination of domestic targets, both GDP and CPI inflation rates and domestic output, with no explicit target for the nominal exchange rate.
In short, policymakers that act in their self-interest do not generally achieve outcomes that are optimal from a global perspective. However, it still possible that monetary institutions can be designed with self-oriented targets that maintain enough flexibility to accommodate also external objectives and solve the problem of international monetary policy cooperation.
The paper is structured as follows. Section 1 presents the structure of the model. Section 2 presents the cooperative and non-cooperative problems. Section 3 solves the problems in a log-linear approximation to the solution under the special condition that the monopolistic distortions are completely neutralized. Section 4 presents the general case. Section 5 concludes.
We have shown that in a two-country general equilibrium model characterized by goods and financial markets integration, the efficient paths of the exchange rate and prices depend on the source of the disturbance that hits the economy. The interaction between the existing distortions and source of disturbance generates, in general, gains from cooperation so that policymakers that maximize their own welfare behave inefficiently in the non-cooperative allocation. This lack of coordination can be amended by assigning simple targeting rules to each policymaker so that the optimal cooperative outcome can be achieved. Surprisingly, these rules depend only on domestic variables despite full goods and capital market integration.
Further research should investigate the robustness of these findings for economies in which asset markets are incomplete and in which consumer prices are less responsive to exchange rate changes as in Devereux and Engel (2003).
Another important open issue is the enforcement of the proposed targeting rules. We have briefly addressed this issue acknowledging that, as in previous contributions in the literature, the cooperation problem is simply shifted at the delegation stage to a supranational authority.
