Abstract
This paper uses an overlapping generations model to analyze monetary policy in a two-country model with asymmetric shocks. Agents insure against risk through the exchange of a complete set of real securities. Each central bank is able to commit to the contingent monetary policy rule that maximizes domestic welfare. In an attempt to improve their country’s terms of trade of securities, central banks choose to commit to costly inflation in favorable states of nature. In equilibrium the effects on the terms of trade wash out, leaving both countries worse off. Countries facing asymmetric shocks may therefore gain from monetary cooperation.
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We are indebted to an anonymous referee, Pedro Alvarez-Lois, Subir Chattopadhyay, Jordi Galí, Berthold Herrendorf, Tommaso Monacelli, Ignacio Ortuño, Javier Vallés, and especially Ronald McKinnon for helpful comments and discussions. We acknowledge the financial support of Fundación BBVA, the Ministry of Science and Technology (BEC 2002-03715), the Comunidad de Madrid (06/0096/03), and the Commission for Cultural, Educational and Scientific Exchange between the United States of America and Spain (Project 7–42). Much of this research was carried out while Klaus Desmet was visiting the Bank of Spain and Stanford University, and he wishes to thank the hospitality of both institutions. The views expressed are those of the authors and not necessarily those of the Spanish Prime Minister’s Bureau.
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Celentani, M., Conde-Ruiz, J.I. & Desmet, K. Inflation in Open Economies with Complete Markets. Economic Theory 31, 271–291 (2007). https://doi.org/10.1007/s00199-006-0091-9
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DOI: https://doi.org/10.1007/s00199-006-0091-9