Much of the recent literature on monetary policy coordination assumes that non-cooperative governments faced by an inflationary shock will try to export inflation through competitive exchange rate appreciations. Two similar countries forcing appreciation by means of monetary policy will undermine each others' effort and end up with excessively contractionary policies, so that both exchange rates will appreciate excessively vis-à-vis the rest of the world. These results depend on the price effect, whereby the appreciation reduces the cost of imports and therefore exerts a deflationary effect, which partly counteracts the initial shock.

In Discussion Paper No. 440 Research Fellows Daniel Cohen and Charles Wyplosz analyse the effects of allowing also for a trade effect, whereby appreciation reduces domestic output at a given level of inflation, thus worsening the impact of the initial shock. If the trade effect dominates the output-inflation trade-off for two non-cooperating countries, they will fear appreciation vis-à-vis each other, and their muffled policy stance will prevents them from exploiting fully the benefit of a joint appreciation vis-à-vis the rest of the world.

Cohen and Wyplosz also consider a shock that is adverse for one country, but favourable for the other, in which case if the trade effect dominates then both countries will do too much relative to the optimally coordinated response since each government will underestimate the other's response. Full coordination, in contrast, would limit policy action to minimize opposing trade effects. Finally, for the case where monetary policies are coordinated, but fiscal policies left in the hands of non-cooperative authorities, the inefficient fiscal-policy outcome remains much the same, but monetary policy policy is more expansionary, since the central monetary authority anticipates the inefficient fiscal policies and compensates with a more active policy stance.

These results carry important policy implications for Europe. If trade effects dominate, then symmetric supply-side shocks are likely to be met with relatively inactive monetary and fiscal policies, while asymmetric shocks may lead to excessive use of both policies which would divide the European countries. Further, the coordination of European monetary policy in the absence of fiscal policy coordination will always imply accommodation than is socially desirable. The results for both types of shock when trade effects dominate appear to contradict the view of the Delors Committee that fiscal policy is biased towards excessive interventionism.

Price and Trade Effects of Exchange Rate Fluctuations and the Design of Policy Coordination
Daniel Cohen and Charles Wyplosz