International monetary policy coordination in a new Keynesian model with NICE features

ABSTRACT

The authors provide a static two-country new Keynesian model to teach two related questions in international macroeconomics: the international transmission of unilateral monetary policy decisions and the gains coming from the coordination monetary rules. They concentrate on “normal times” and use a thoroughly graphical approach to analyze the questions at hand. In this setting monetary policy is conducted using interest rates rules and economic integration between nations does not necessarily create the case for the coordination of monetary policy. In particular, they show that the conduct of optimal national monetary policies does not make any difference with the coordination of national policies, as this creates a situation where the international monetary system operates “Near an International Cooperative Equilibrium” (NICE).

KEYWORDS:

• economic policy
• international macroeconomics
• monetary policy
• New Keynesian macroeconomics
• optimal interest rate rules

JEL CODES:

• A20
• E10
• E50
• F41

Acknowledgments

The authors thank William Walstad, David Colander and four anonymous referees for helpful comments that allowed them to improve the initial version of this article. They thank Louise Rimbert and Anais Moison for skillful assistance.

Notes

1. An alternative story is provided by Oudiz and Sachs (1984) where coordination issues arise from a disinflation game between two countries. The economic rationale for international monetary policy coordination stems from the presence of nonpecuniary externalities in the conduct of national monetary policy. The explanation is cast in the following terms: by appreciating the exchange rate each country seeks to “export” inflation. Because in equilibrium, they cannot both appreciate, the Nash equilibrium is characterized by overly tight monetary policy and a correspondingly large output gap and unemployment. Under cooperation, they do not engage in this futile game, and inflation is a bit higher but unemployment lower.

2. As underlined by John Taylor (2013, 4), “Empirical research beginning in the early 1980s predicted that the gains from international coordination of monetary policy would be quantitatively small compared to those achieved from each central bank following a monetary policy which optimized its own country's economic performance. …. By choosing policies that worked well domestically attempts to formally coordinate policy choices across countries would probably have added little to macroeconomic stability during the Great Moderation. …. The international monetary system was operating near an internationally cooperative equilibrium (NICE).”

3. An extended version of this article provides a companion analysis in a two-country version of the small open-economy model provided by Carlin and Soskice (2015, chapter 9). It is available at the following address: https://sites.google.com/view/poutineau/research

4. Incorporating fiscal policy along the lines of Bofinger, Mayer, and Wollmershäuser (2006) is a straightforward extension of the model for treating questions related to the implementation of fiscal policy in an integrated world. This extension (not covered here) can be done easily to assess the contribution of fiscal policy decisions to current account fluctuations.

5. This effect is similar to the one observed in the Mundell-Fleming model following an increase in the domestic money supply. Assuming that the foreign country does not match the domestic country policy, its currency appreciates in real terms relative to the domestic country's, thereby reducing its exports via the expenditure switching effect. Thus fluctuations in the terms of trade act as a pecuniary externality between countries, following unilateral interest rate manipulations.

6. As underlined by Debortoli et al. (2017), describing the objectives of central banks using a loss function combining inflation and the output gap is a parsimonious way of approximating social welfare, as banks are typically subject to a mandate involving only a few variables. Woodford (2003) provides a proof of the correspondence of the loss function and the maximization of social welfare. Noticeably, solving the central bank problem gives rise to a targeting condition representing its relative concern between stabilizing inflation and activity reflecting its mandate. However, the operational policy instrument (the short-run interest rate) is computed using this targeting rule. For a recent quantitative illustration of this approach using a loss function to characterize the Fed policy, see Debortoli et al. (2017).

7. Assuming the same weight on inflation and output this loss function is a circle centered on the bliss point where L=0.