The Role of Financial Market Structure and the Trade Elasticity for Monetary Policy in Open Economies

Imperfect international risk sharing and exchange rate volatility matter for how monetary policy should optimally be conducted in an open economy: these features lead to optimal deviations from the inward-looking behavior of solely stabilizing domestic inflation and affect terms of trade considerations of policymakers. I study these motives for a classical and long-standing question in international monetary economics: the size of potential gains from international policy coordination. In a standard two-country model with monopolistic competition and nominal rigidities I allow for various degrees of risk sharing by considering different assumptions on international financial markets -- complete markets, financial autarky and a bond economy -- and a large region for the crucial parameter of the trade elasticity. The incentive of terms of trade manipulation, that is, the attempt of policymakers to influence international relative prices in their own favor, is shown to be particularly strong when international prices are very volatile. When incomplete markets give rise to high exchange rate volatility and poor risk sharing -- such as in Corsetti et al. (2008)--, gains from policy coordination are shown to be an order of magnitude larger than previous studies, working under the assumptions of complete financial markets, suggest.