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Optimal Monetary Policy and the Sources of Local-Currency Price Stability

Giancarlo Corsetti (), Luca Dedola () and Sylvain Leduc ()

No 2007/26, RSCAS Working Papers from European University Institute

Abstract: We analyze the policy trade-offs generated by local currency price stability of imports in economies where upstream producers strategically interact with downstream firms selling the final goods to consumers. We study the effects of staggered price setting at the downstream level on the optimal price (and markup) chosen by upstream producers and show that downstream price movements affect the desired markup of upstream producers, magnifying their price response to shocks. We revisit the international dimensions of optimal monetary policy, unveiling an argument in favour of consumer price stability as the main prescription for monetary policy. Since stable consumer prices feed back into a low volatility of markups among upstream producers, this contains inefficient deviations from the law of one price at the border. However, efficient stabilization of different CPI components will not generally result into perfect stabilization of headline inflation. National policies optimally respond to the same shocks in a similar way, thus containing volatility of the terms of trade, but not necessarily of the real exchange rate. The latter will be more volatile, among other things, the larger the home bias in expenditure and the content of local inputs in consumer goods.

Keywords: optimal monetary policy; price discrimination; price dispersion; exchange rate pass through; real exchange rates (search for similar items in EconPapers)
JEL-codes: F31 F33 F41 (search for similar items in EconPapers)
Date: 2007-11-09
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mon and nep-opm
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Related works:
Chapter: Optimal Monetary Policy and the Sources of Local-Currency Price Stability (2007) Downloads
Working Paper: Optimal Monetary Policy and the Sources of Local-Currency Price Stability (2007) Downloads
Working Paper: Optimal Monetary Policy and the Sources of Local-Currency Price Stability (2007) Downloads
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