Current account dynamics and optimal monetary policy in a two-country economy

Abstract

This paper explores optimal monetary policy when current account dynamics is taken into consideration in a sticky–price intertemporal optimising model. It investigates how monetary policies affect current account movement in a two–country model. The main issues addressed include: 1) what factors affect the current account dynamics in response to technology and monetary shocks in a two–country open economy; 2) how should the monetary authority respond to these shocks to maximise the welfare of the household. Using a non–linear solution method, we find that the current account dynamics depends critically on the intratemporal and intertemporal elasticities of substitution, the degree of monopolistic competition, the degree of Local Currency Pricing (LCP) and the type of shocks. With sluggish price adjustment among firms, the home monetary authority will choose an expansionary monetary policy when facing a home technological improvement. If a supranational monetary authority is to choose an optimal monetary policy for both countries, the welfare gain from the expansionary monetary policy for both home and foreign counties is quantitatively small.