Research Discussion Papers, Bank of Finland
No 15/1997:
A Model of Common Monetary Policy
Juha Tarkka ()
Abstract: This paper analyses the prerequisites for and the results
of unanimous monetary policy decisions in a monetary union consisting of
heterogeneous members. The analysis is based on a multicountry version of
Rogoff's model of the determination of monetary policy in the presence of
supply shocks. It is shown that an international transfer system can be
designed which creates consensus both on the average rate of inflation and
the common response to asymmetric shocks to the participating economies. We
conjecture that this kind of transfer mechanisms, institutionalized or
informal, supporting joint decisions tend to evolve in contexts where there
is strong aversion of disagreement. Monetary policy is arguably such a
context, because frequent disagreement within the decision-making body
could be harmful to credibility. The transfer system capable of supporting
consensus on monetary policy can be based on activity-related, automatic
subsidies for countries which would individually prefer lower inflation
rates, and activity-related taxes for countries which would prefer higher
inflation in absence of the transfer system. It turns out that the common
monetary policy created by unanimous decisions under the supporting
transfer mechanism can be characterized as a weighted average of the
national "stand-alone" inflation rates, i.e. the rates which would prevail
without the monetary union. The weights of the countries are not related to
the sizes of the national economies, but rather to the national attitudes
towards inflation and transfer income. Countries with a low stand-alone
rate of inflation get a large weight in the determination of the common
monetary policy, as do the countries which have a relatively low marginal
valuation of international transfer income.
Keywords: positive inflation theory; monetary union; monetary policy; (follow links to similar papers)
20 pages, September 10, 1997
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