International market linkages and optimal monetary policy

Abstract

The interrelation among portfolio choice and labor supply decisions and real balance effects is examined under flexible exchange rates. On the asset menu are home currency, domestic government bonds and foreign bonds. With commodity market linkages the real balance effect is highlighted as the inefficiency of an economy with positive government bonds is demonstrated, while the additional linkage of interest rates through covered interest parity may transform an economy where only money is useful into an economy in which both money and government bonds are beneficial.