When does coordination pay?

Abstract

In a continuous-time model of two symmetric open economies, with a floating exchange rate, we find that the pay-off to macroeconomic policy coordination depends systematically on how heterogeneous is their inflation experience. While monetary policy coordination improves welfare in handling a common rate of underlying inflation, it exacerbates the ‘time consistency’ problem arising when there are differences (as is illustrated diagrammatically). Since the principle of ‘certainty equivalence’ applies to time-consistent policy in linear quadratic models, we are also able to give a stochastic interpretation of the deterministic results.