International dimensions of optimal monetary policy$

This paper provides a baseline general equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities. An inwardlooking policy of domestic price stabilization is not optimal when firms’ markups are exposed to currency fluctuations. Such a policy raises exchange rate volatility,leading foreign exporters to charge higher prices vis-a` -vis increased uncertainty in the export market. As higher import prices reduce the purchasing power of domestic consumers,optimal monetary rules trade off alarger domestic output gap against lower consumer prices. Optimal rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies,even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a nonmonotonic way to the degree of exchange rate pass-through. r 2005 Elsevier B.V. All rights reserved