O Senay, A Sutherland /Joumal of International Economics 117(2019)196-208 that transitory shocks can have very long lasting effects on net foreign References ssets. In the absence of any deliberate policy response, this tends to the variance of consumption and work effort and thus has poten Beaudry, P. Portier, F- 2006. Stock prices, news, and economic fluctuations. Am. Econ. ev.96.1293-1 tially strong negative effects on welfare. Optimal policy tends to counter Benigno, P. 2009. Price stability with imperfect financial integration. J. Money Credit these effects by placing a stronger emphasis on the risk sharing gap in Bank41.121-14 the policy rule (i.e. the parameter op)for low values of n(as can be Benigno, G. Benigno, P, 2003. Price stability in open economies. Rev. Econ. Stud. 70, seen in Table 9). A policy of inflation targeting on the other hand ignores Benigno, P. Woodford, M., 2005. Inflation stabilization and welfare: the case of a distorted the implications of volatile net foreign assets for welfare and thus the Eur. Econ. Assoc 3. 1185-1236 welfare performance of inflation targeting is significantly lower than Bodenstein. M: 2012 Trade elasticities of substitution and equilibrium dynamics. J Econ. optimal policy when n) is small. It therefore follows that, as shown in Calvo, G.A 1983. Staggered prices in a utility-maximizing framework L. Monet. Econ. 12. Table 9, the welfare gain from optimal policy is larger for small values of n. Note however that, for small values of n, the variances of consum Christiano, L, Eichenbaum, M Evans, C. 2005. Nominal rigidities and the dynamic effects tion and work effort are unrealistically large, so the large welfare gains Clarida R. Gali, L Gertler, M, 2002. A simple framework for international monetary pol- from optimisation are not empirically plausible. Cole, HL, Obstfeld, M 1991. Commodity trade and international risk sharing: how much Corsetti, G, Dedola, L, Leduc, S, 2010. Optimal monetary policy in open economies. Hand- book of Monetary Economics VoL3B Ben Friedman and Michael Woodford. Elsevier. Recent literature on monetary policy in open economies(Corsetti et Corsetti, G Dedola, L, Leduc, S 2018. "Demand imbalances, exchange rate misalignment aL, 2010, 2018 )shows that, when international financial trade is absent neary policy trade-offs"centre for or restricted to a single non-contingent bond, there are significant inter- nal and external trade-offs that prevent optimal policy from simulta- Damjanovic, T. Damjanovic V.Nolan, C, 2008.Unconditionally optimal monetary policy neously closing all welfare gaps In this case optimal monetary policy De Paoli, B. 2010. Monetary policy under altemative asset market structures: the case of a deviates from inflation targeting in order to offset real exchange rate Money, Credit, Bank. 41, 1301-1330 misalignments. These simple models of financial market incomplete- Devereux. M Sutherland, A 2008. Financial g obalization and monetary policy.J. Monet ness provide important theoretical insights but they are obviously not Devereux, M, Sutherland, A, 201. Country portfolio dynamics. J. Econ. Dyn. Control. 34. develops a more realistic model of incomplete markets, where there Devereux, M- Sutherland, A, 2010b Valuation effects and the dynamics of net extemal is international trade in multiple assets. The analysis shows that the Devereux, M. Sutherland, A, 2011a Solving for country portfolios in open economy presence of multiple assets creates a potentially powerful interaction between monetary policy and household portfolio allocation. This inter- Devereux M, Sutherland, A, 2011b Evaluating international financial integration under leverage constraints. Eur. Econ. Rev. 55. 427-442. ction is, by definition, not present when there is financial autarky or a Devereux, M, Senay, 0., Sutherland, A, 2014. Nominal stability and financial globaliza- single tradeable bond and this paper shows that the interaction tion ]. Money Credit Bank 46(5). 921-939 with portfolio allocation can imply that optimal monetary policy gener- Engel, C, 2011. Currency misalignments and optimal monetary policy: a re-examination. ates a quantitatively much more significant stabilisation of the real change rate gap than implied by simpler models of financial market This paper focuses on a model of imperfect financial markets where Rabisch. k,, 2012) Ece e of financi/mark o rechange rate volatility in a small open Gali J, Monacelli, T, 2005. Monetary policy and the trade elasticity for mon- the imperfection simply takes the form of a restricted set of financial in- etary policy in open economies. J. Money, Credit, Bank. 44. 603-629 struments(i.e bonds and equities)which is insufficient to provide full Samuelson, P, 1970. The fundamental approximation theorem of portfolio analysis in international risk sharing. Devereux and Sutherland(2011b)show Schmit-Grohe S, Uribe, M, 2003. Closing small open economy models.IntEcon. that the presence of collateral constraints can significantly alter the in- 137-159. ernational transmission of shocks, especially in the case when there Senay, O- Sutherland, A 2013. The timing of asset trade and optimal policy in dynamic is trade in bonds and equity. In a companion paper (Senay and Senay, o. Sutherland. A. 2016. Country portfolios, collateral constraints and optimal published Manuscript. University of the above model which has been extended to incorporate collateral Smets, F- Wouters, R, 2003. An estimated stochastic general equilibrium model constraints Smets, F. Wouters, R 2005. Comparing shocks and frictions in US and euro area business cycles: a Bayesian DSGE approach. J AppL Econ. 20, 161-183 Appendix A Supplementary material ts, f, wouters, R, 2007. Shocks and frictions in US business cycles: a Bayesian DSG oach. Am. Econ. Re Tille. C van Wincoop, E. 2010. Intermational capital flows. J. Int. Econ. 80, 157-175. Matlabfilesrelatingtothisarticlecanbefoundonlineathttps://doi.WoodfordM.2003.Interestandpricesfoundationsofatheoryofmonetarypolicy org/10.1016/ JInteco.2018.12001that transitory shocks can have very long lasting effects on net foreign assets. In the absence of any deliberate policy response, this tends to raise the variance of consumption and work effort and thus has poten￾tially strong negative effects on welfare. Optimal policy tends to counter these effects by placing a stronger emphasis on the risk sharing gap in the policy rule (i.e. the parameter δD) for low values of η (as can be seen in Table 9). A policy of inflation targeting on the other hand ignores the implications of volatile net foreign assets for welfare and thus the welfare performance of inflation targeting is significantly lower than optimal policy when η is small. It therefore follows that, as shown in Table 9, the welfare gain from optimal policy is larger for small values of η. Note however that, for small values of η, the variances of consump￾tion and work effort are unrealistically large, so the large welfare gains from optimisation are not empirically plausible. 7. Conclusions Recent literature on monetary policy in open economies (Corsetti et al., 2010, 2018) shows that, when international financial trade is absent or restricted to a single non-contingent bond, there are significant inter￾nal and external trade-offs that prevent optimal policy from simulta￾neously closing all welfare gaps. In this case optimal monetary policy deviates from inflation targeting in order to offset real exchange rate misalignments. These simple models of financial market incomplete￾ness provide important theoretical insights but they are obviously not good representations of modern financial markets. This paper therefore develops a more realistic model of incomplete markets, where there is international trade in multiple assets. The analysis shows that the presence of multiple assets creates a potentially powerful interaction between monetary policy and household portfolio allocation. This inter￾action is, by definition, not present when there is financial autarky or a single tradeable bond and this paper shows that the interaction with portfolio allocation can imply that optimal monetary policy gener￾ates a quantitatively much more significant stabilisation of the real ex￾change rate gap than implied by simpler models of financial market incompleteness. This paper focuses on a model of imperfect financial markets where the imperfection simply takes the form of a restricted set of financial in￾struments (i.e. bonds and equities) which is insufficient to provide full international risk sharing. Devereux and Sutherland (2011b) show that the presence of collateral constraints can significantly alter the in￾ternational transmission of shocks, especially in the case when there is trade in bonds and equity. In a companion paper (Senay and Sutherland, 2016) we analyse optimal monetary policy in a version of the above model which has been extended to incorporate collateral constraints. Appendix A. Supplementary material Matlab files relating to this article can be found online at https://doi. org/10.1016/j.jinteco.2018.12.001. References Beaudry, P., Portier, F., 2006. Stock prices, news, and economic fluctuations. Am. Econ. Rev. 96, 1293–1307. Benigno, P., 2009. Price stability with imperfect financial integration. J. Money Credit Bank. 41, 121–149. Benigno, G., Benigno, P., 2003. Price stability in open economies. Rev. Econ. Stud. 70, 743–764. Benigno, P., Woodford, M., 2005. Inflation stabilization and welfare: the case of a distorted steady state. J. Eur. Econ. 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Sutherland / Journal of International Economics 117 (2019) 196–208