DP4385 Inflation in Open Economies with Complete Markets

Author(s): Marco Celentani, José Ignacio Conde-Ruiz, Klaus Desmet
Publication Date: May 2004
Keyword(s): currency union, inflation, monetary cooperation, risk sharing, security markets, terms of trade
JEL(s): E50, F30, F42
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4385

This Paper uses an overlapping generations model to analyse 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 may choose to commit to costly inflation in favourable 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.