Price and trade effects of exchange rate fluctuations and the design of policy coordination

Abstract

We analyze a two-country zone facing a joint inflationary shock and responding with coordinated and uncoordinated monetary and fiscal policies. We show that the standard presumption that the absence of coordination results in an excessive exchange rate appreciation of the zone with respect to the rest of the world hinges on a specific assumption: within the two countries considered, the price effect of exchange rate fluctuations dominates the trade effects relative to the corresponding effects via-à-vis the rest of the world. If the relative hierarchy goes the other way around (as we argue is likely for EC countries), the standard conclusion is reversed, a result of insufficiently active monetary and fiscal policies. The paper also considers asymmetric shocks as well as monetary policy coordination.