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There is a wide acceptance that gains to international monetary policy coordination are small at best and that the need of policy coordination is questionable. This conclusion, however, follows from the underlying presumption that monetary policy is concerned with the stabilization of macroeconomic fluctuations only. This paper presents a general short-run monetary policy analysis within a familiar two-country New Open Economy Macroeconomics (NOEM) framework where national monetary policy involves the choice of a deterministic growth trend of money supply (average inflation rate) and stochastic, state-dependent deviations of actual money supply from the deterministic trend (stabilization). Strategic “beggar-thy-neighbor” considerations induce the deviation of both policy choices from their socially optimal values. The gains from international coordination of the average inflation rate are of first-order and hence larger than the gains from the coordination of the stabilization policies which are of second-order.

In Open Economy Macroeconomics, the study of international monetary policy cooperation has a long tradition. Game-theoretic arguments making the case for international policy coordination are based on the rationale first provided by Hamada (1974): Welfare gains from policy coordination may arise from the prevention of any strategic consideration to use national monetary policy so as to unilaterally manipulate the terms of trade in one country's own favor.1 The paradigmatic consensus in the literature, however, is that gains from policy coordination are small at best. The aim of this paper is to stress that this conclusion follows from the underlying presumption that monetary policy is concerned with the stabilization of macroeconomic fluctuations. As it is widely accepted, welfare gains from stabilizing macroeconomic fluctuations are per se quite limited.2 Gains from international monetary policy coordination are consequently limited if cooperation is restricted to stabilization issues only. Considering instead more general monetary policy conduct reveals that the very same incentives that lead monetary authorities to strategically alter national responses to macroeconomic shocks also shift monetary policy conduct on average and independently of any exogenous economic disturbances. Crucially then, the welfare consequences of monetary policy coordination are substantially different from those of coordinating stabilization policies alone. To demonstrate this, I use a version of the familiar monetary two-country economy studied by Corsetti and Pesenti (2001) and Obstfeld and Rogoff (2000, 2002). In this simple dynamic stochastic general equilibrium model that has a closed-form solution, monetary non-neutrality stem from preset wages and cash-in-advance restrictions. National monetary authorities follow money supply rules that involve two policy choices: a deterministic growth rate or trend of money supply and stochastic, state-dependent deviations of actual money supply from the deterministic trend. On the one hand, altering the deterministic trend of money supply affects the allocation via the expected (and on average realized) inflation rate and thus the nominal interest rate. Higher average money growth increases inflation and also the nominal interest rate on average. The nominal interest rate, however, reflects the opportunity cost of holding money wage payments as wealth. An increase in the nominal interest rate therefore prompts households to claim higher nominal wages. This in turn raises marginal costs of production, final goods prices, and causes thus an appreciation of the terms of trade. As a result, the non-stochastic trend of the money supply rule forms an effective policy instrument to manipulate the terms of trade on average. In the rational expectations equilibrium, there is a unique relationship between the deterministic growth rate or trend of money supply and the nominal interest rate that works through the inflation expectations. Each level of the trend (and hence the average) of money supply corresponds to a different nominal interest rate. Because the results of the analysis become much clearer, I exploit this one-to-one relationship and argue directly in terms of the nominal interest rate as the policy choice.3 On the other hand, the presence of nominal rigidities allows monetary authorities to alter the equilibrium allocation by means of state-dependent deviations of actual money supply from the deterministic trend. Since it cannot be fully offset by adjustments in prices and wages, an unexpected contraction of the actual money supply which appreciates the nominal exchange rate then also leads to an appreciation of the terms of trade. This is the familiar monetary policy channel to respond to economic fluctuations as widely discussed in the literature. I shall refer to it as the (active) money supply management. Within this framework, two important observations stand out: First, the state-dependent (active) money supply management affects the equilibrium allocation by changing the variance of the equilibrium distribution. The nominal interest rate policy affects the equilibrium allocation by directly moving the mean of the equilibrium distribution. Consequently, the equilibrium and hence welfare implications of the nominal interest rate policy are of first-order whereas those of the money supply management are of second-order. Second, self-interested national policymakers face an incentive to deviate from the globally optimal interest rate policy for exactly the same reason why they deviate from the globally optimal money supply management. From a global perspective, the Friedman rule is optimal since it minimizes the wedge between the marginal rate of substitution and the marginal rate of transformation in all instances when wages are flexible and at least on average when wages are sticky. Independent and self-oriented national policymakers, however, strive for an appreciation of the terms of trade by increasing inflation on average. Ceteris paribus, this improves the domestic labor-leisure trade-off in all instances when wages are flexible and at least on average when wages are sticky. The same rationale holds true for the money supply management. Independently operated money supply management will deviate from the global optimum because the authorities want to appreciate their respective terms of trade in order to improve the labor-leisure trade-off. The deviations of both the nominal interest rate policy and the money supply management are always “beggar-thy-neighbor”. The important conclusion to be drawn then is that gains from international arrangements or institutions that effectively prevent these strategic interactions are of first-order. A simple numerical example demonstrates that international coordination of nominal interest rate policy can amount to welfare gains four orders of magnitude larger than gains from coordinating stabilization policies through money supplies. Consequently, potential gains from policy coordination are not negligible. The rest of the introduction provides a discussion of the related literature. The model is presented in the next Section, and the equilibrium allocation is described in Section 3. Section 4 portrays the general monetary policy conduct and explores the welfare consequences of nominal interest rate policy and money supply management. The analysis of optimal monetary policy when set cooperatively and independently follow in Sections 5 and 6, respectively. A numerical example in Section 7 provides an assessment of the quantitative relevance of the findings. Section 8 concludes. 1.1. Discussion of the literature Beginning with Hamada (1974), the first generation of game-theoretic models, including Hamada (1976), Oudiz and Sachs (1984), and Canzoneri and Gray (1985),4 are based on traditional Keynesian models where policymakers are assumed to minimize an ad hoc motivated quadratic loss function that punishes deviations from given desired levels or blisspoints of the inflation rate, the increase in international reserves, or the output level. Conditioning on those policy objectives leads immediately to the result of limited gains for two reasons: First, the quadratic loss function itself directly reduces the problem to the minimization of deviations around the blisspoints. The consequence is that gains from coordinating monetary policy must be of second-order. Second, the studies neglected that the blisspoints themselves are subject to strategic considerations. A proper notion of the desired levels of inflation or output conditioning on the international macroeconomic environment, however, requires a rigorous microeconomic foundation. The second generation of policy coordination models as in Corsetti and Pesenti (2001), Obstfeld and Rogoff (2002), and Devereux and Engel (2003) are embedded into the New Open Economy Macroeconomics (NOEM) framework that brings optimizing agents, monopolistic competition and nominal rigidities into dynamic general equilibrium models.5 Nevertheless, even though the second generation models provide new important insights to the question of the needs of international policy coordination, welfare gains are still quite limited. In contrast to the first generation models, however, the answer to this problem is now inherent to the specification of the conduct of policy itself. In one prominent class of models, as for example in Clarida et al. (2002) and Galí and Monacelli (2005), it is assumed that policymakers follow interest rate rules that condition on deviations of inflation rates and output from some given reference levels. Equivalent to the problem of exogenous blisspoints discussed above, both the average interest rate as well as the reference value for the inflation and output deviations are not further analyzed but implicitly fixed via the (log)linear approximation of the model about a zero inflation and nonstrategic steady state. In the other prominent class of models, as for example in Obstfeld and Rogoff (2002) and Devereux and Engel (2003), it is assumed that monetary authorities follow policy rules that condition money supply deviations from any given initial stock of money on the realization of shocks. The average inflation rate induced by the mean growth rate of the money supply is also implicitly assumed to be zero. In both classes of models, monetary policy solely focuses on stabilization issues and consequently the welfare gains of policy coordination are limited. There are two exceptions from this literature that consider non-stabilizing monetary policy interaction within a strategic setting. Cooley and Quadrini (2003) study optimal interest rate policy in a two-country open economy model that is not a variant of the standard NOEM framework. Instead, they use a limited participation model where purchases of production intermediaries – partly imported – must be financed in advance. Consequently, the nominal interest rate has a distorting effect as it increases the cost of production. In this environment, self-interested monetary authorities face the incentive to increase the nominal interest rate in order to appreciate the terms of trade and thereby to expand domestic production. The policy competition leads to inflationary biases with inefficiencies that have sizable adverse welfare consequences. The other exception is Arseneau (2007) who studies the importance of the distortion caused by monopolistic competition for the optimal nominal interest rate policy. Arseneau seeks to complement Cooley and Quadrini (2003) where production takes place in a perfectly competitive environment. He shows that the presence of imperfect competition dampens the incentive to use the nominal interest rate strategically within. The present paper contributes to the literature by providing a unified analysis of both the nominal interest rate policy and the money supply management within a familiar NOEM framework. The paper provides a clear distinction of different strategic aspects of international monetary policy because the framework allows the insulation of inflationary biases from stabilization concerns. Moreover, the joint analysis also facilitates the consistent comparison of welfare consequences of those strategic aspects to international monetary policy coordination within a single framework. Related to this paper is also the discussion of optimal inflation targets. Standard monetary economic theory prescribes the Friedman Rule as the optimal monetary policy when nominal distortions stem from the demand for fiat money. It prescribes zero inflation targeting when nominal distortions stem from nominal rigidities. Schmitt-Grohé and Uribe (2010) point out that this is in contrast to the inflation objectives of most central banks which are significantly above zero. They give examples of deviations from the standard optimality arguments that induce higher inflation targets. Against the background of the arguments put forth in this paper, strategic considerations of monetary policy in open economies also provide a potential rationale for positive inflation targets.

Within the large body of the literature on international monetary policy coordination, the broad consensus is that gains from policy coordination are small if not negligible. This view is corroborated by theoretical considerations that focus on the coordination of international monetary stabilization policies. While these contributions certainly deserve their very merits for revealing important insights, the limited quantitative importance cannot be surprising: by focussing on short-run demand side management, stabilization policies target the variability of the equilibrium allocation. They are hence generically of second-order. However, to plagiarize Lucas (2003), the “potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management”. The present paper takes up this proposition and introduce it into the context of international monetary policy coordination. The arguments are formalized within a familiar and tractable version of the New Open Economy Macroeconomics (NOEM) framework. Monetary authorities can manipulate the terms of trade by conducting a general short-run monetary policy using both the nominal interest rate and state-dependent money supply management. On the one hand, the money supply management affects the allocation and the terms of trade ex post by altering relative nominal spending and thereby the nominal exchange rate. In this respect, monetary policy is used in the traditional way so as to stabilize macroeconomic fluctuations by fine tuning spending flows. On the other hand, the nominal interest rate affects the allocation and the terms of trade ex ante by altering the households' wage setting conditions and thereby goods prices. In this respect, monetary policy changes the incentives to work and might cause inefficiencies on the supply side. It is demonstrated that the resulting welfare implications of nominal interest rate policy are of first-order whereas the welfare implications of money supply management are of second-order. The important consequence is that gains from coordinating money supply management are generically of second-order if they focus on stabilization issues. In contrast, gains from preventing excessively high inflation rates and hence nominal interest rates resulting from self-interested strategic manipulations of the terms of trade are of first-order and hence expected to be of higher order of magnitude. A numerical example of the simple model already indicates that welfare gains from globally optimal monetary policy conduct might be substantial. The present analysis of more general monetary policy conduct in interdependent economies leads to the conclusion that gains from policy coordination might have been to a large extend underestimated.