Joumal of International Economics 117(2019)196-208 Contents lists available at Science Direct Journal of International economics ELSEVIER journalhomepagewww.elsevier.com/locate/jie Optimal monetary policy, exchange rate misalignments and incomplete financial markets☆ Ozge Senay a *, Alan Sutherland b Universiry of St Andrews, School of Economics and Finance, St Andrews, KY169AL, UK CEPR University of St Andrews. St Andrews, KY16, UK ARTICLE O A BSTRACT Recent literature shows that, when international financial trade is restricted to autarky or a single bond, there are Received 13 February 2017 Received in revised form 18 November 2018 internal and external welfare trade-offs that imply optimal monetary policy, in principle, deviates from inflation targeting in order to offset real exchange rate misalignments. This paper develops a more realistic model of in- Available online 27 December 2018 mplete markets, where there is international trade in multiple assets. The analysis shows that the presence f multiple assets creates a potentially powerful interaction between monetary policy and household portfolio location. This interaction 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 aerates a quantitatively much more significant stabilisation of the real exchange rate gap than implied by sim- pler models of financial market incompleteness. O 2019 Elsevier B V. All rights reserved. rket structure Country portfolios 1 Introduction Benigno and Benigno(2003)showed that optimal cooperative mone- tary policy should focus on targeting the rate of inflation of producer To what extent should the design of monetary policy rules explic- prices. These authors demonstrate that a policy of inflation targeting itly account for open economy factors such as current account imbal- is sufficient to close all internal and external welfare gaps. There is ances or exchange rate misalignments? Recent literature has therefore no trade-off between internal and external policy objectives. emphasised the key role of imperfections in international financial This early open economy literature, however, focused on models where arkets in creating a trade-off between internal and extemal objec- international financial markets are complete. Households can therefore tives of monetary policy. The aim of this paper is to extend the anal- fully hedge against country specific income shocks. More recent litera- ysis of this question to a model with international trade in multiple ture has begun to analyse monetary policy in open economy models assets but where there are insufficient assets to hedge against all where financial markets are incomplete. For instance, Corsetti et al sources of shocks simultaneously. We show that monetary policy(2010, 2018)analyse cooperative monetary policy in a context where can have a significant effect on welfare via its impact on portfolio al- international financial trade is absent or is restricted to a single non- location. This provides a strong incentive to direct monetary policy contingent bond. They show that, in contrast to the previous literature, away from internal objectives (i.e. inflation stabilisation)and towards when international financial markets are incomplete there an external objective (i.e. stabilisation of the real exchange rate around its first-best level) This paper is a contributi monetary policy in open economies. The early literature emphasised that open economy factors need have no explicit role in the design of optimal cooperative monetary policy rules. For instance, a world level in order to maximize world welfare. In some special cases, see for instance Clarida et al. (2002)and Gali and Monacelli(2005), optimal cooperative policy is identical to non-cooperative policy, but this is not true in general ny helpful comments on an earlier draft of this paper. This basic closed economy results of woodford (2003)and Benigno and woodford (2005). research is supported by ESRC Award Number ES/1024174/1 The only difference between the closed and open economy results is in the choice of price index for the inflation target- consumer prices for a closed economy and producer prices E-mail address: os12@st-andac uk(O Senay). for an open economy. ttps: //doiorg/10. 1016/jinteco 2018. 12.001 0022-1996/6 2019 Elsevier B V. All rights reserved.Optimal monetary policy, exchange rate misalignments and incomplete financial markets☆ Ozge Senay a, ⁎, Alan Sutherland b a University of St Andrews, School of Economics and Finance, St Andrews, KY16 9AL, UK b CEPR, University of St Andrews, St Andrews, KY16 9AL, UK article info abstract Article history: Received 13 February 2017 Received in revised form 18 November 2018 Accepted 5 December 2018 Available online 27 December 2018 JEL: E52 E58 F41 Recent literature shows that, when international financial trade is restricted to autarky or a single bond, there are internal and external welfare trade-offs that imply optimal monetary policy, in principle, deviates from inflation targeting in order to offset real exchange rate misalignments. This paper develops a more realistic model of in￾complete 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 interaction 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 generates a quantitatively much more significant stabilisation of the real exchange rate gap than implied by sim￾pler models of financial market incompleteness. © 2019 Elsevier B.V. All rights reserved. Keywords: Optimal monetary policy Financial market structure Country portfolios 1. Introduction To what extent should the design of monetary policy rules explic￾itly account for open economy factors such as current account imbal￾ances or exchange rate misalignments? Recent literature has emphasised the key role of imperfections in international financial markets in creating a trade-off between internal and external objec￾tives of monetary policy. The aim of this paper is to extend the anal￾ysis of this question to a model with international trade in multiple assets but where there are insufficient assets to hedge against all sources of shocks simultaneously. We show that monetary policy can have a significant effect on welfare via its impact on portfolio al￾location. This provides a strong incentive to direct monetary policy away from internal objectives (i.e. inflation stabilisation) and towards an external objective (i.e. stabilisation of the real exchange rate around its first-best level). This paper is a contribution to a long-running literature on optimal monetary policy in open economies. The early literature emphasised that open economy factors need have no explicit role in the design of optimal cooperative monetary policy rules. For instance, Benigno and Benigno (2003) showed that optimal cooperative mone￾tary policy should focus on targeting the rate of inflation of producer prices.1 These authors demonstrate that a policy of inflation targeting is sufficient to close all internal and external welfare gaps. There is therefore no trade-off between internal and external policy objectives.2 This early open economy literature, however, focused on models where international financial markets are complete. Households can therefore fully hedge against country specific income shocks. More recent litera￾ture has begun to analyse monetary policy in open economy models where financial markets are incomplete. For instance, Corsetti et al. (2010, 2018) analyse cooperative monetary policy in a context where international financial trade is absent or is restricted to a single non￾contingent bond. They show that, in contrast to the previous literature, when international financial markets are incomplete there are Journal of International Economics 117 (2019) 196–208 ☆ We are grateful to Giancarlo Corsetti, Charles Engel, Oliver de Groot, Kemal Ozhan and two anonymous referees for many helpful comments on an earlier draft of this paper. This research is supported by ESRC Award Number ES/I024174/1. ⁎ Corresponding author. E-mail address: os12@st-and.ac.uk (O. Senay). 1 In this paper we focus on optimal cooperative policy, i.e. a world where policy is set at a world level in order to maximize world welfare. In some special cases, see for instance Clarida et al. (2002) and Gali and Monacelli (2005), optimal cooperative policy is identical to non-cooperative policy, but this is not true in general. 2 This early literature is in effect a direct extension to an open economy setting of the basic closed economy results of Woodford (2003) and Benigno and Woodford (2005). The only difference between the closed and open economy results is in the choice of price index for the inflation target - consumer prices for a closed economy and producer prices for an open economy. https://doi.org/10.1016/j.jinteco.2018.12.001 0022-1996/© 2019 Elsevier B.V. All rights reserved. Contents lists available at ScienceDirect Journal of International Economics journal homepage: www.elsevier.com/locate/jie