LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Macroeconomics In Open Economies
Optimal Monetary Policy in Open Economies Complete Markets and Cooperation: Local Currency Price Stability Simon P. Lloyd
[email protected] University of Cambridge
August 2014
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Main Results: Corsetti et al. (2010)
Complete Markets, Cooperation and Producer Currency Pricing: Divine Coincidence Breaking the ’Divine Coincidence’ I
Complete Markets, Cooperation and Local Currency Pricing F
Incomplete exchange rate pass through → Price dispersion within and across markets.
F
Optimal Policy: In general, trade-off internal and external objectives.
F
Two special cases: (1) linear disutility of labour; and (2) PPP.
I
Complete Markets and Strategic Interaction
I
Incomplete Markets
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Outline: Complete Markets, Cooperation and Local Currency Price Stability 1
Local Currency Pricing (LCP) I
Tweaking the Model (Corsetti et al., 2010)
I
The General Case Special Cases
I
F
Linear Disutility of Labour (Engel, 2011)
F
Purchasing Power Parity (PPP) (Clarida et al., 2002; Benigno and Benigno, 2003)
I
Simulation in the General Case: Optimal Stabilisation an Macroeconomic Volatility
2
Real vs. Nominal Determinants of Local Currency Price Stability: Destination Specific Markup from Distribution Costs (Corsetti et al., 2008, 2009)
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Three Key Points LCP ⇒ Deviations from the law of one price (LOOP): ∆H,t =
∗ εt PH,t PH,t
and
∆H,t ≡ ∆F ,t ≡ ∆t . Incomplete Exchange Rate Pass Through Exchange Rate Depreciation ↑ εt ⇒ ToT Improvement ↓ Tt =
PF ,t ∗ εt PH,t
ER movements cannot have expenditure switching effects. Nominal depreciation ↑ the domestic currency revenue from selling good abroad. New Keynesian Phillips Curve πH,t − βEt πH,t+1
=
(1 − αβ)(1 − α) n bH,t − Y˜ fb + µ (η + σ) Y bt H,t α(1 + θη) h io bt − ∆ bt −(1 − aH ) 2aH (σφ − 1) Tbt − T˜tfb + ∆
∗ Four NKPCs, for {πH,t , πH,t , πF ,t , πF∗ ,t }, tracking the behaviour of inflation
at the consumer price level. Price dispersion within and across markets. Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Households Utility function for a consumer j in country H: (∞ " #) 1−σ Z X Ctj − 1 1 n −η yt (h)1+η j V = E0 ζC ,t − ζ dh 1−σ n 0 Y ,t 1 + η t=0 Consumption basket: Ct =
φ−1
1/φ aH CH φ
+
φ−1 φ
1/φ aF CF
φ φ−1
where: θ # θ−1 " Z 1/θ n θ−1 1 Ct (h, j) θ dh CH,t (j) ≡ n 0 θ " Z # θ−1 1/θ n θ−1 1 CF ,t (j) ≡ Ct (f , j) θ df n 0
with θ > φ. Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
(1)
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Intra-temporal Household Optimisation Utility-based CPI for country H: 1 h i 1−φ 1−φ Pt = aH PH,t + (1 − aH )PF1−φ ,t
(2)
where PH,t and PF ,t are sub-indexes, respectively defined as: PH,t
1 Z n 1−θ 1 1−θ ≡ Pt (h) dh n 0
, PF ,t
1 ≡ 1−n
Z
1 1−θ
n 1−θ
Pt (f )
df
0
Demand by individual j in country H: I
For brand h of good H: Ct (h, j) = aH
I
Pt (h) PH,t
−θ
PH,t Pt
−φ
Ctj
(3)
For brand f of good F : Ct (f , j) = (1 − aH )
Simon P. Lloyd
Pt (f ) PF ,t
−θ
Optimal Monetary Policy: CM & LCPS
PF ,t Pt
−φ
Ctj August 2014
(4)
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Inter-temporal Household Optimisation Individual flow budget constraint for representative home agent under complete markets: Z BH,t+1 + qH,t (st+1 )BH,t (st+1 )dst+1 ≤ (1 + it )BH,t + BH,t R Pt (h)yt (h)dh +(1 − τt ) − PH,t Tt − PH,t CH,t − CF ,t PF ,t n Inter-temporal Euler Equation: " # −σ Ct+1 Ct−σ ζC ,t = (1 + it )Et βζC ,t+1 Pt Pt+1
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
(5)
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Goods Market Clearing Production Function: η
yt (h) = ζY1+η ,t lt (h)
(6)
Total Real Cost: −
η
tct = wt ζY ,t1+η yt (h) where wt is the real wage. The real marginal cost is given by: −
η
mct = wt ζY ,t1+η
(7)
Goods Market Equilibrium: yt (h) = ytd (h) ≡
Simon P. Lloyd
Pt (h) PH,t
−θ
PH,t Pt
−φ
Optimal Monetary Policy: CM & LCPS
[aH Ct + (1 − aH )Ct∗ ]
August 2014
(8)
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Price Setting: LCP LCP: Price rigid in the destination currency ⇒ Firms set Pt (h) for domestic markets and set export prices in foreign currency Pt∗ (h). α = α∗ ∈ [0, 1) cannot change nominal price; 1 − α reset price optimally. The home firm’s problem can be written: ∞ X UC ,t+s s (1 − τt+s ) max∗ Et (αβ) Pt+s {pt (h),pt (h)} s=0 " −θ −φ pt (h) PH,t+s × pt (h) (aH Ct+s ) PH,t+s Pt+s !−θ −φ ∗ ∗ P p (h) H,t+s t ∗ +εt+s pt∗ (h) (1 − aH )Ct+s ∗ ∗ PH,t+s Pt+s −V (yt+s|t (h), ζY ,t+s ) subject to its demand function. Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Taking first-order conditions with respect to pt (h) and pt∗ (h) yields: ∞ X θ UC ,t+s s Pt (h) − Vy (yt+s|t (h), ζY ,t+s ) Et (αβ) Pt+s (1 − τt+s )(θ − 1) s=0 " #) −θ −φ Pt (h) PH,t+s × (aH Ct+s ) = 0 (9) PH,t+s Pt+s
Et
∞ X
s
(αβ)
s=0
−
UC ,t+s εt+s Pt∗ (h) Pt+s θ
(10)
Vy (yt+s|t (h), ζY ,t+s ) (1 − τt+s )(θ − 1) !−θ −φ ∗ ∗ P P (h) H,t+s t ∗ × =0 (1 − a )C H t+s ∗ ∗ PH,t+s Pt+s
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
∗ As PH,t and PH,t are sticky, then LOOP is violated with any movement in
the exchange rate. Since all producers that reset their price in period t will choose the same price level, there are now four equations that describe the ∗ dynamic evolution of the prices indexes PH,t , PH,t , PF ,t and PF∗,t :
PH,t 1−θ = αPH,t−1 1−θ + (1 − α)Pt (h)
1−θ
(11)
1−θ
(12)
1−θ ∗ ∗ 1−θ + (1 − α)Pt∗ (h) PH,t = αPH,t−1
1−θ
(13)
1−θ
(14)
PF ,t 1−θ = α∗ PF ,t−1 1−θ + (1 − α∗ )Pt (f )
PF∗,t 1−θ = α∗ PF∗,t−1 1−θ + (1 − α∗ )Pt∗ (f ) where α∗ = α.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Exchange Rate Determination Intimately linked with the structure of international asset markets. Complete Markets: Price equalisation in market for state contingent claims BH,t implies perfect international risk sharing: Ct∗ −σ ζC∗ ,t Ct−σ ζC ,t = Pt εt Pt∗ Using the definition of the real exchange rate Qt = Qt =
Ct∗ −σ ζC∗ ,t Ct−σ ζC ,t
≡
εt Pt∗ Pt ,
this becomes:
UC (Ct∗ , ζC∗ ,t ) UC (Ct , ζC ,t )
(15)
⇒ Home per capita consumption can only rise relative to foreign per capita income if the real exchange rate depreciates.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Optimal Policy in the General Case In general, the are no clear-cut prescriptions for policy. Though there are special cases, which we consider in the next section. Global stabilisation under LCP is generally achieved by trading off: inefficient cross-country output gap differentials; terms of trade misalignments; and deviations from the law of one price. The main lesson: I
Under LCP, policymakers should pay greater attention to consumer price inflation components, rather than GDP deflator inflation.
I
Policymakers should attend to international relative price misalignments.
I
However, LCP motivates neither complete CPI stabilisation within countries, nor policies containing real exchange rate volatility.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
The Optimal Policy Problem Cooperation, commitment, timeless perspective and monopolistic distortions offset by appropriate subsidies: 2 2 1 PCP−CM fb bH,t + (σ + η) Y˜ fb − Y bF ,t (σ + η) Y˜H,t Lt n− −Y F ,t 2 i θα(1 + θη) h 2 ∗ 2 aH πH,t + (1 − aH )πH,t + aH πF∗ ,t 2 + (1 − aH )πF2 ,t + (1 − αβ)(1 − α) | {z } Consumer Level Inflation Rates
h i2 2aH (1 − aH )(σφ − 1)σ fb bH,t − Y˜ fb − Y bF ,t − Y˜H,t −Y F ,t 2 4aH (1 − aH )φσ + (2aH − 1) | {z } Cross-Country Output Gap Differences
2aH (1 − aH )φ + 4aH (1 − aH )φσ + (2aH − 1)2
b2 ∆ t |{z}
LOOP Deviations
b t. This loss is minimised subject to NKPCs, choosing πH,t , πF∗ ,t , YˆH,t , YˆF ,t , ∆ Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Consumer Level Inflation Rates: I
Four inflation terms reflect that, with LCP, inefficiency in the supply of each good arises from price dispersion within and across markets.
Deviations from the Law of One Price (LOOP): I
Leads to inefficiencies in the level and composition of global consumption demand.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Optimal Targeting Rules
Cross-country sum targeting rule: h bH,t − Y˜ fb − Y bH,t−1 − Y˜ fb 0 = Y H,t H,t−1 i bF ,t − Y˜ fb − Y bF ,t−1 − Y˜ fb + Y F ,t F ,t−1 ∗ +θ aH πH,t + (1 − aH )πF ,t + (1 − aH )πH,t + aH πF∗ ,t Policymakers seek to stabilise global output gap and world price inflation (defined in terms of consumer prices). I
Under PCP: policymakers stabilise global output gap and world price inflation, expressed in terms of either consumer or producer prices.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Cross-country difference targeting rule mathematically involved, but general implications are: I
Combine flexible inflation target and a price-level target in terms of consumer prices, which are adjusted to account for relative price misalignments.
I
Account for differentials in the GDP deflator inflation across countries:
∗ aH πH,t + (1 − aH )πH,t − (1 − aH )πF ,t + aH πF∗ ,t
and differences in CPI inflation: I
∗ (aH πH,t + (1 − aH )πF ,t ) − (1 − aH )πH,t + aH πF∗ ,t
Cross-country differentials are optimally traded off with cross-country differentials in output gaps and relative price misalignments, including deviations from LOOP.
I
Global stabilisation generally comes at the expense of national CPI inflation and output gap stabilisation.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Optimal Policy in the General Case: Code Dynare Code: dyn 03 lcp cm coop.mod and dyn 03 lcp cm coop news.mod MATLAB Code: figs 03 transmission lcp.m and figs 03 transmission lcp news.m I
Section 1: Home Productivity and Preference Shocks (Positive) for φ = 0.7
I
Section 2: Home Markup Shock (Negative) for φ = 0.3, 0.5, 0.7
Must run dyn 03 lcp cm coop.mod for elas sub equal to 0.3, 0.5 and 0.7 respectively, saving each impulse response under a different name (e.g. ... low; ... mid; and ... high). Must ensure that load(·) commands include valid file directories.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
The Transmission of Efficient Shocks Figure : LCP - CM - Cooperation - Home Productivity and Preference Increases
φ = 0.7 and σ = 2 such that σφ > 1. Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Under LCP, even if shocks are fully efficient, they cannot be fully stabilised under optimal policy. Positive productivity shock at home opens a negative output gap with negative GDP deflator inflation. I
Home policy expansionary (CPI inflation rises), depreciating the real and nominal exchange rate. However, the terms of trade will appreciate.
I
The home expansion and ToT appreciation translates into excessive demand for foreign goods, which results in a positive foreign output gap and a rise in foreign GDP deflator inflation.
I
Foreign policy contractionary.
I
CPI inflation is stabilised to a larger extent than the GDP deflator inflation.
Positive preference shock at home opens a positive output gap with positive GDP deflator inflation. I
Monetary authorities react by contracting policy, appreciating the currency. However, with LCP the home appreciation will weaken the terms of trade.
I
Home demand for the foreign good will fall, despite stronger demand for home output.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Exercise “The allocation in the Foreign country is ... determined by monetary spillovers, rather than the elasticity parameters” (Corsetti et al., 2010, p. 904). Verify this claim by attaining the impulse responses to positive home productivity and preference shocks when φ = 0.3, such that σφ < 1 (i.e. when home and foreign goods are complements).
Key: The opposing movements of the (R)ER and ToT are integral to the monetary spillovers that occur with optimal policy under LCP.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
The Transmission of Inefficient Shocks Figure : LCP - CM - Cooperation - Home Markup Decrease under Optimal Policy
φ = 0.3, 0.5, 0.7 in the first, second and third columns respectively. σ = 2 in all columns. Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
As for efficient shocks, alternative values of σφ are not relevant for the direction of cross-border spillovers (unlike under PCP). A decrease in home markups is met with a domestic policy expansion. This creates a positive cross-border output spillover that is independent of σφ. I
A home expansion will depreciate the real exchange rate and, with LCP, appreciate the terms of trade.
I
An improved terms of trade translates into excessive demand for foreign goods, which results in a positive foreign output gap.
Relative to PCP, international relative prices move in opposite directions under LCP: home RER depreciates, while the ToT strengthen.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Anticipated Home Productivity Shocks Figure : LCP-CM-Coop. - Anticipated Positive Home Prod. Shock
φ = 0.7 and σ = 2 such that σφ > 1. Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Optimal Policy in Two Special Cases
1
Linear Disutility of Labour (η = 0) (Engel, 2011)
2
PPP (aH = 1/2) (Clarida et al., 2002; Benigno and Benigno, 2003)
Cross-country difference targeting rule simplifies to: i h fb bt − Q b ˜ fb ˜ − Q − Q 0 = σ −1 Q t−1 t t−1 ∗ +θ (aH πH,t + (1 − aH )πF ,t ) − (1 − aH )πH,t + aH πF∗ ,t
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Clear-cut policy prescription under special cases: I
Efficient Shocks: Set all inflation terms to zero and stabilise average output gap at global level. ⇒ Strict CPI inflation targeting and complete stabilisation of real exchange rate misalignments (‘Optimal Real Exchange Rate Stabilisation’)
I
Inefficient Shocks: Optimal policy in response to shocks retains internal and external objectives, as in the general case.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Optimal Stabilisation and Volatility Run simulations to compare the volatility of macroeconomic variables under PCP and LCP with optimal policy. Four Simulations: 1
PCP: Productivity and Preference Shocks ONLY F
2
F 3
Dynare Code: dyn 05 pcp sim ppmk.mod
LCP: Productivity and Preference Shocks ONLY F
4
Dynare Code: dyn 04 pcp sim pp.mod
PCP: Productivity, Preference AND Markup Shocks
Dynare Code: dyn 06 lcp sim pp.mod
LCP: Productivity, Preference AND Markup Shocks F
Dynare Code: dyn 07 lcp sim ppmk.mod
Simulate each model for 5000 periods I
MATLAB Code: sim 01 pcp lcp.m
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Table : Calibration Parameter Values
Preferences and Technology Risk Aversion
σ=2
Prob. of Resetting Price
1 − α = 0.25
Inverse Frisch Labour Supply Elasticity
η = 1.5
Elasticity of substitution between... ... Home and Foreign Goods
φ = 0.5
... Brands of Home Good
θ=6
Home Bias
aH = 0.9
Shocks Productivity
ρz = 0.95, σz = 0.001
Preferences
ρζ = 0.95, σζ = 0.001
Markup
σµ = 0.001
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Table : Volatilities of Macroeconomic Variables under Optimal Policy and Complete Markets: PCP vs. LCP
PCP Statistics
Prod.
LCP
With
Prod.
Markup
and
Shocks
Shocks
Shocks
Shocks
CPI Inflation
0.11
0.11
0.02
0.03
GDP Deflator Inflation
0.00
0.03
0.02
0.04
Output Gap
0.00
0.15
0.06
0.15
Markup
0.00
0.53
0.11
0.52
and
Pref.
With Pref.
Markup
Standard Deviation in %
Standard Deviation Relative To Output Real Exchange Rate
1.49
1.40
1.67
1.57
Terms of Trade
1.93
1.82
1.44
1.35
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
With efficient steady state, optimal policy under PCP reproduces the flex-price efficient allocation if shocks are efficient. I
Markups, the output gap and GDP deflator inflation are all perfectly stabilised.
I
Inward looking policy stabilises prices of domestic producers in domestic currenct.
I
CPI inflation remains quite volatile.
With markup shocks, policymakers optimally trade off markup and inflation stabilisation under PCP, with output gap stabilisation.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Relative to PCP, policy under LCP no longer fully stabilises domestic output gap, whether or not shocks are efficient. CPI inflation volatility is now lower than GDP deflator inflation. I
Optimal policy attempts to stabilise a weighted average of domestic and foreign markups.
Under LCP the ToT is less volatile than with PCP and the RER is more volatile. I
Impulse responses from LCP suggest that policy is more concerned with RER gap stabilisation (remember the linear disutility special case (Engel, 2011)!).
I
BUT: LCP simulations show that RER level is more volatile than the ToT level.
I
Implication: What matters for policymakers are welfare-relevant gaps, rather than variables in levels.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Problems with LCP
Obstfeld and Rogoff (2000): Models attributing local currency price stability solely to nominal rigidities (i.e. LCP) cannot be consistent with the empirical regularity that exchange rate depreciation is systematically associated with worsening terms of trade. I
For (log) exchange rate and terms of trade indexes 1982-1998: d (εUK , TUK ) = 0.42, Corr d (εUS , TUS ) = 0.31. Corr
Lubik and Schorfheide (2005): An unrealistically high degree of LCP price stickiness is required to match the degree of exchange rate pass through seen in the data.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
An Example Optimal Markup Adjustment of Firms/Pricing To Market (PTM)
Corsetti et al. (2008): Model with vertical interaction due to the presence of distribution services intensive in local inputs (non-tradable goods). I
When distribution services are combined with LCP price stickiness that is consistent with the data (Bils and Klenow, 2004), the real and nominal exchange rates are positively correlated with the terms of trade.
I
The results are also consistent with empirical estimates of ERPT.
Corsetti et al. (2009): Optimal monetary policy with distribution services and nominal LCP rigidities at both the producer and retailer level. I
Several layers of nominal rigidities create trade offs between price stability and relative price adjustment, which need to be addressed by optimal stabilisation policies.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
LCP: The Model
Optimal Policy in the General Case
Special Cases
Macro Volatility
Real & Nominal Determinants
Conclusion Evidence supports the view that there exists local currency price stability, which can be modeled in different ways: I
Nominal Rigidities - Local Currency Pricing (LCP): Incomplete exchange rate pass through. F
Corsetti et al. (2010): With complete markets and cooperation, the optimal monetary policy involves trading-off internal and external objectives in the general case.
F I
Two special cases: (1) linear disutility of labour; and (2) PPP.
Local Costs and Destination Specific Markups (Corsetti et al., 2008)
Corsetti et al. (2009): Build layers of nominal rigidities (for up- and downstream firms) alongside distribution costs for downstream firms.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
References
Benigno, G. and P. Benigno (2003): “Price Stability in Open Economies,” Review of Economic Studies, 70, 743–764. Bils, M. and P. J. Klenow (2004): “Some Evidence on the Importance of Sticky Prices,” Journal of Political Economy, 112, 947–985. Clarida, R., J. Gali, and M. Gertler (2002): “A simple framework for international monetary policy analysis,” Journal of Monetary Economics, 49, 879–904. Corsetti, G., L. Dedola, and S. Leduc (2008): “High exchange-rate volatility and low pass-through,” Journal of Monetary Economics, 55, 1113–1128. ——— (2009): “Optimal Monetary Policy and the Sources of Local-Currency Price Stability,” in International Dimensions of Monetary Policy, National Bureau of Economic Research, Inc, NBER Chapters, 319–367. ——— (2010): “Optimal Monetary Policy in Open Economies,” in Handbook of Monetary Economics, ed. by B. M. Friedman and M. Woodford, Elsevier, vol. 3 of Handbook of Monetary Economics, chap. 16, 861–933. Engel, C. (2011): “Currency Misalignments and Optimal Monetary Policy: A Reexamination,” American Economic Review, 101, 2796–2822.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
References
Lubik, T. and F. Schorfheide (2005): “A Bayesian Look at the New Open Economy Macroeconomics,” in NBER Macroeconomics Annual 2005, Volume 20, National Bureau of Economic Research, Inc, NBER Chapters, 313–382. Obstfeld, M. and K. Rogoff (2000): “New directions for stochastic open economy models,” Journal of International Economics, 50, 117–153.
Simon P. Lloyd
Optimal Monetary Policy: CM & LCPS
August 2014
