Policy Cooperation, Incomplete Markets, and Risk Sharing

Charles Engel

IMF Economic Review, 2016, vol. 64, issue 1, 103-133

Abstract: The paper derives “targeting rules” for optimal policy in a simple two-country model in which financial markets are incomplete and policy is noncooperative. The optimal rules are compared with the cooperative case. Although the model is simple, it is complex enough so that the distortion introduced by incomplete financial markets matters. The complete markets case serves as a benchmark. Under complete markets, it is shown that the policy response in one state of the world influences outcomes in all other states through the effect on asset prices. It is noted that monetary policy cannot replicate an optimal tariff, so that the absence of a tariff instrument is a distortion even in the complete-markets economy. We show that optimal policy, even under complete markets and cooperation, does not try to minimize spillovers.

Date: 2016
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