Productive and Counterproductive Cooperative Monetary Policies

Abstract

The main result of this paper is that, contrary to the usual conclusion (and presumption) of earlier analyses, increased monetary policy cooperation between two governements does nto automatically increase welfare in either country. In fact, welfare in one or both countries may be higher when central banks conduct their monetary policies independently. It is true that a cooperative regime does produce better responses to certain types of unanticipated disturbances (such as supply shocks or relative shifts in aggregate demand). But when monetary policy is fully discretionary, inter-central bank cooperation can also lead to systematically higher expected rates of inflation: private sector wage setters will choose higher rates of nominal wage growth if they rationally fear that the central banks will coordinate their efforts to lower real wages and raise employment. (The conflict between wage setters and central banks is generated by some type of labor market distortion which causes the natural rate of unemployment to be too high.) Therefore, monetary policy cooperation is unambigously beneficial only in institutional frameworks which eliminate or ameliorate the central banks' credibility problem vis-a-vis wage setters.