Chapter

Optimal Monetary Policy and the Sources of Local-Currency Price Stability

Giancarlo Corsetti, Luca Dedola and Sylvain Leduc

in International Dimensions of Monetary Policy

Published by University of Chicago Press

Published in print March 2010 | ISBN: 9780226278865
Published online February 2013 | e-ISBN: 9780226278872 | DOI: http://dx.doi.org/10.7208/chicago/9780226278872.003.0007
Optimal Monetary Policy and the Sources of Local-Currency Price Stability

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This chapter describes the mechanism and implications of globalization that raises the sensitivity of inflation to movements in exchange rates. The evidence from industrialized economies suggests that pass-through of exchange rate movements into import prices is imperfect. A model of imperfect pass-through is developed that is based on a combination of nominal rigidities and endogenous destination-specific markup adjustment. This model of imperfect pass-through is then integrated into a complete dynamic monetary stochastic general equilibrium (DSGE) model with nominal rigidities, in order to study the implications for optimal monetary policy. It is also shown that the optimal policy does not necessarily imply that the real exchange rate should be less volatile than the terms of trade; whether that is the case or not depends on a number of characteristics of the economies involved.

Keywords: globalization; inflation; pass-through; exchange rate; dynamic monetary stochastic general equilibrium; DSGE; local-currency price

Chapter.  18099 words.  Illustrated.

Subjects: Macroeconomics and Monetary Economics

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