International Transmission of Monetary Shocks with Interest Rate Rules

Abstract

This paper explores the implications of monetary policy rules in the general equilibrium two-country framework of Obstfeld and Rogoff (1995). It is argued that the sign of the correlation of domestic and foreign outputs can be positive after a monetary shock, contrary to the standard result. The reason is that an interest rate rule targeting the consumer price index implies less volatile terms of trade and this reduces the expenditure switching effect, and thus the demand effect through the fall of the real interest rate prevails. It is also shown that inertia in the interest rate rule is a necessary condition for the model to display persistence of the real variables after a shock to the interest rate rule.