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Monetary Policy Rules in a Two-Country World

Kollmann, Robert (2002): Monetary Policy Rules in a Two-Country World.


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This paper computes welfare-maximizing Taylor-style interest rate rules, in a business cycle model of a two-country world. The model assumes staggered price setting, violations of the Law of One Price, due to pricing-to-market, and productivity shocks, as well as shocks to the uncovered interest rate parity (UIP) condition--these shocks can be interpreted as reflecting biased exchange rate forecasts by "noise traders". Optimized policy rules closely replicate the equilibrium under price flexibility. Monetary policy coordination (joint maximization of world welfare) yields very limited welfare gains, compared to the Nash outcome. UIP shocks have a non-negligible negative effect on welfare, especially when these shocks are highly persistent, and when trade linkages between the two countries are strong. The adoption of an exchange rate peg may thus be welfare improving, if the adoption of the peg reduces the variance of the UIP shocks. The model explains thus the propensity of very open economies to peg their exchange rate vis-à-vis their main trading partners.

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