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In a two country world where each country has a traded and a non-traded sector and each sector has sticky prices, optimal independent policy in general cannot replicate the natural-rate allocations. There are potential welfare gains from coordination since the planner under a cooperating regime internalizes a terms-of-trade externality that independent policymakers overlook. If the countries have symmetric trading structures, however, the gains from coordination are quantitatively small. With asymmetric trading structures, the gains can be sizable since, in addition to internalizing the terms-of-trade externality, the planner optimally engineers a terms-of-trade bias that favors the country with a larger traded sector.

As countries become more interdependent through international trade, should they conduct monetary policies independently or should they coordinate their policies? In other words, are there gains from international monetary policy coordination? This question lies at the heart of the intellectual discussions about optimal monetary policy in open economies. The literature has produced a strong conclusion in favor of inward-looking policies and flexible exchange-rate regimes. This conclusion has been drawn not only in the traditional literature within the Mundell–Fleming framework that features ad hoc stabilizing policy goals, but also in the more recent New Open-Economy Macro (NOEM) literature that features optimizing individuals, monopolistic competition, and nominal rigidities, with the representative household's utility function serving as a natural welfare metric for optimal policy. In the traditional literature, many have argued that the gains from coordination are likely to be small because a flexible exchange-rate system would effectively insulate impacts of foreign disturbances on domestic employment and output (e.g., Mundell, 1961 and McKibbin, 1997). In the NOEM literature pioneered by Obstfeld and Rogoff (1995), it has been shown that, although gains from coordination are theoretically possible, they are quantitatively small (e.g., Obstfeld and Rogoff, 2002 and Corsetti and Pesenti, 2001). The remarkably strong conclusion about the lack of gains from coordination has stimulated a lively debate and a growing strand of literature in search of sources of coordination gains by enriching the simple framework built by Obstfeld and Rogoff (2002). Several potential sources have been identified. For instance, the gains from coordination can be related to the degree of exchange-rate pass-through (e.g., Devereux and Engel, 2003, Duarte, 2003 and Corsetti and Pesenti, 2005).1 Even with perfect exchange-rate pass-through, inward-looking monetary policy can be suboptimal and be improved upon by coordination, depending on the values of the intertemporal elasticity and the elasticity of substitution between goods produced in different countries (e.g., Clarida et al., 2002, Benigno and Benigno, 2003 and Pappa, 2004). Policy coordination may also produce welfare gains if the international financial markets are incomplete (e.g., Sutherland, 2002), policymakers have imperfect information (e.g., Dellas, 2006), or domestic shocks are imperfectly correlated across sectors (e.g., Canzoneri et al., 2005). Most of the studies on international policy coordination focus on countries with similar characteristics. The theoretical framework used in these studies typically features two countries that are identical except that they might be buffeted by different shocks. Such a framework is not suitable, and indeed, is not designed to address issues on policy coordination between countries at different stages of development or countries with different institutional structures that render their production and trading structures asymmetric. Recent events such as the rise of China as an increasingly important player in the world economy and the accession of some Eastern European countries to the European Monetary Union render it important to understand the implications of international policy coordination between dissimilar countries. The present paper takes a first step in this direction by emphasizing the role of cross-country differences in trading structures in generating gains from policy coordination. For this purpose, we build a two-country model in the spirit of the NOEM literature, with two production sectors within each county. One sector produces traded goods that enter the consumption baskets in both countries, and the other sector produces non-traded goods that enter the domestic consumption basket only. To allow for real effects of monetary policy, we assume monopolistic competition (e.g., Blanchard and Kiyotaki, 1987) and staggered price setting (e.g., Calvo, 1983) in both sectors. A key point of departure from the NOEM literature is that we allow the share of traded goods in the consumption basket to be different across countries.2 One possible interpretation of the asymmetry here is that it may reflect differences in tastes. For instance, the Americans seem to enjoy spending a large share of their income on housing services or paying for the services provided by their local dealers at various stages of distribution, while the Chinese seem to love McDonald's, Starbucks, and Dell computers. Another possible interpretation of the asymmetry assumed in our model is that it may capture cross-country differences in production structures as a consequence of different technology progress. For instance, if technology progress is faster in the manufacturing sector than in the service sector and goods and services are poor substitutes, then the long-run share of the service sector will rise and the manufacturing sector will decline (e.g., Ngai and Pissarides, 2007). Different patterns of technology progress can thus create differences in production structures across countries. A third possibility is that, in the presence of transportation cost or other trade barriers, some goods are traded but others are not (e.g., Eaton and Kortum, 2002 and Melitz, 2003). Cross-country differences in trade policy or transportation technologies may thus create differences in the relative size of the traded sector. Finally, if the countries involved have different sizes of the government sector, then, to the extent that public services are not traded, the countries should also have different shares of expenditure on non-traded goods, as we assume in our model. There are many other possible interpretations of the structural asymmetry in our model. However, understanding the sources of such asymmetry is beyond the scope of our current paper. We focus on examining how the presence of multiple sectors and sectoral asymmetries across countries affects macroeconomic stability and welfare under independent and cooperating policy regimes. To isolate the role of asymmetric trading structures, we make two assumptions that simplify our analysis. First, we assume log-utility in aggregate consumption, a unitary elasticity of substitution between traded and non-traded goods in the consumption baskets, and a unitary elasticity of substitution between domestically produced traded goods and imported goods. Second, we assume the existence of a complete international financial market so that country-specific risks are perfectly insured. Although these assumptions typically go against the need for international policy coordination (e.g., Clarida et al., 2002 and Pappa, 2004; Sutherland, 2002), we still obtain sizable welfare gains from coordination in our model with structural asymmetry. The gains from coordination arise through three channels. First, optimal independent policy cannot replicate the natural-rate allocations when facing multiple sources of domestic nominal rigidities, creating a scope for coordination. Second, under a cooperating regime, the social planner internalizes a terms-of-trade externality that independent policymakers overlook. Third, with symmetric trading structures, welfare gains from coordination are quantitatively small; but with asymmetric structures, the gains can be sizable because, in addition to internalizing the terms-of-trade externality, the planner engineers a terms-of-trade bias in favor of the country with a larger traded sector. This bias originates from differences in the countries’ initial wealth levels. In the optimal-policy problem, the planner needs to balance the terms-of-trade bias against the desire to stabilize fluctuations in the terms-of-trade gap, among other variables in the policy objective derived from the first principle. We further show that the welfare gain from policy coordination increases with the share of imported goods in the traded consumption baskets and with the durations of pricing contracts; but decreases with the correlation of domestic shocks. Our work contributes to the literature in two aspects. First, by introducing asymmetric structures in an otherwise standard two-sector NOEM model, we have identified the terms-of-trade bias as a new channel of welfare gains from cooperation. The model enables us to go beyond the special results obtained in the literature (e.g., Obstfeld and Rogoff, 2002) and to find sizable welfare gains from international policy coordination. Second, we make a methodological contribution to the literature by deriving an explicit expression for the welfare objective both for the independent policy regime and for the cooperating regime. To our knowledge, we are the first to derive such a welfare criterion in an open economy with multiple sectors based on quadratic approximations of households’ utility functions.3

We have revisited the issue of gains from international monetary policy coordination in a framework that generalizes the standard model in the NOEM literature by introducing both traded and non-traded goods, and more importantly, by allowing for a structural asymmetry across countries in the size of the traded sector. For this purpose, we have derived welfare measures through second-order approximations to the households’ utility functions and to the private sector's optimizing conditions. We find that the welfare gains arise from two channels. The first channel is standard in the NOEM literature and is independent of the structural asymmetry in the model: if acting independently, a national policymaker does not care about the effects of terms-of-trade movements on the other country's well being; whereas when the countries cooperate, this terms-of-trade externality would be properly recognized and efforts would be made to internalize it. The second channel is unique to our model and works only through structural asymmetries across countries: the planner's optimal policy under the cooperating regime involves a terms-of-trade bias that favors the country with a larger traded sector; and this bias has to be balanced against the need to stabilize fluctuations in the terms-of-trade gap, among other variables in the policy objective. Absent structural asymmetry, the welfare gains from coordination are quantitatively small; as the degree of asymmetry enlarges, so do the welfare gains. With plausible structural asymmetries, policy coordination results in sizable welfare gains. Further, all else equal, the gains are larger if the countries have a greater share of imported goods in their traded basket, if the domestic shocks are less correlated, or if the duration of pricing contracts is longer. Although the terms-of-trade bias identified in this paper arises from the same principles as does the terms-of-trade externality described in the NOEM literature, their implications for the gains from coordination are quite different. In the case with symmetric structures across countries, there is no terms-of-trade bias under cooperation and the welfare gains arise solely from internalizing the terms-of-trade externality. Under plausible parameters, such gains are quantitatively small. A stronger case for policy coordination can be made when the countries involved have asymmetric trading structures. In our analysis, we have focused on a particular form of cross-country asymmetries. Of course, there are other forms of structural asymmetries that might be relevant for international monetary policy analysis. For instance, countries may have different trend components of traded-sector productivity, they may have different abilities to access international financial markets, or they may have different labor market institutions. Modeling structural differences along these dimensions may have important implications for understanding the consequences of international policy coordination. For the purpose of studying optimal monetary policy, we assume that fiscal policies are ‘passive’ in the sense that they are needed only to the extent that production subsidy rates are chosen to achieve optimal steady-state allocations. Further, the planner's weighting scheme can be interpreted as a ‘bargaining’ outcome between fiscal authorities in countries with asymmetric structures. A natural extension would be to study the implications of international coordinations in both fiscal policy and monetary policy in a model like ours. Future research along these lines should be both fruitful and promising. The current paper represents a first step toward this direction.