928 Giancarlo Corsetti et al.

7. CONCLUSIONS
This chapter addressed the question of how optimal monetary policy should be con-
ducted in interdependent open economies, proposing a unified analytical framework
to systematize the existing literature, and pointing to new directions of research.
According to received wisdom, the answer to our question is that macroeconomic
interdependence is relevant to the optimal monetary conduct only to the extent that it
affects domestic output gaps and inflation. Therefore, the optimal policy prescriptions
are the same as those derived in the baseline monetary model abstracting from openness
and can be readily applied in terms of the same targeting rules in output gaps and GDP
inflation. As shown in this chapter, however, such an answer turns out to be a good
guide to policy making only under two key special conditions: a high responsiveness
of import prices to the exchange rate, and frictionless international financial markets
supporting the efficiency of the flexible price allocation. Under general conditions,
optimal policy instead does require policymakers to trade off domestic and external
gaps, that is, to redress misalignments in international relative prices and cross-country
demand imbalances.
Stressing the empirical evidence questioning a high responsiveness of import prices
to the exchange rate, a large body of literature explores the policy implications of stick-
iness in the price of imports in local currency. In this case, there is an optimal trade-off
between output gaps and misalignments in domestic and international relative prices
induced by multiple nominal distortions. The focus of policymakers naturally shifts
from GDP deflator inflation, to CPI inflation, and onto real exchange rate stabilization,
containing deviations from the law of one price.
Similarly, trade-offs between output gaps and the terms of trade emerge when pol-
icymakers do not internalize international monetary spillovers and engage in cross-
country strategic interactions. Reflecting traditional models of competitive devaluation,
the modern paradigm emphasizes the incentives for national policymakers to manipu-
late the terms of trade to raise national welfare that arise in the absence of international
policy coordination.
In addition to the previous two cases extensively discussed in the literature, a third
important source of policy trade-offs with an international dimension are induced by
financial imperfections. Key lessons for monetary policy analysis can be learned from
models in which asset markets do not support the efficient allocation, which is in line
with the notion that misalignments can occur independently of nominal and monetary
distortions, and indeed can be expected to occur per effects of large distortions in
financial markets.
Our analysis focuses on standard open-economy models where restrictions to cross-
border trade in assets result in significant misallocation of consumption and employ-
ment within countries, associated with international demand imbalances and exchange
 The Interaction Between Monetary and Fiscal Policy 985

Three factors determine optimal inflation in the cash and credit goods model with
the menu of taxes that we consider. The first is the monetary distortion, which pulls
optimal inflation toward the Friedman rule. The second is price stickiness, which pulls
optimal inflation toward zero. Without both consumption and wage taxes available to
the fiscal authorities, the monetary authority cannot ignore price stability in setting its
optimal policy. The absence of a consumption tax implies that consumer and producer
prices are identical and optimal policy must trade off the Friedman and Calvo desider-
ata. Unlike these first two factors, the third “pull” on optimal inflation is not apparent
from the preceding discussion. Inflation, by taxing nominal asset holdings, can provide
an indirect tax on otherwise untaxed income. We will see the effects of this third pull
on inflation when monopoly profits are less than fully taxed.47
The impact of these three “pulls” varies in our simulations, but three conclusions
emerge. First, as is clear from the discussion, optimal monetary policy depends crucially
on instruments available to the fiscal authorities. Second, price stickiness exerts a strong
influence on optimal monetary policy. As Benigno and Woodford (2003) and Schmitt-
Grohe and Uribe (2004a, 2005) find, even a relatively low degree of price stickiness
restores the case for price stability. Both average inflation (or deflation) and inflation
variability are optimally close to zero. Third, because taxing profits is not distortionary,
the incentive to use inflation as an indirect tax on profits is surprisingly strong when
tG, the tax rate on profits, is less than one.
Our aim in presenting these results is to illustrate the factors behind optimal policy, the
interactions between monetary and fiscal policy, and the key results in the literature. We
do not wish to emphasize particular quantitative results because the ultimate balance of the
three pulls depends on details of model specification and auxiliary assumptions.
For example, we use a cash and credit goods model as the source of the distortion arising
from a nonzero interest rate, we assume the elasticity of substitution between the two
goods is one, we adopt Calvo pricing with no indexation, and we do not include capital
in our model so profits are pure rents.48 None of these choices is innocuous and each is
likely to affect our quantitative results.49 Some of the results we present appear to be

47
Here, as in Schmitt-Grohe and Uribe (2004a,b), the third pull arises from the Ramsey planner’s incentive to use
inflation to tax monopoly profits, which are a pure rent and would otherwise be untaxed. In Schmitt-Grohe and
Uribe (2005), the incentive to use inflation to tax transfers, which are a rent to households, plays a similar role. In
Schmitt-Grohe and Uribe (2010), foreign holdings of domestic money balances provide another target for the
inflation tax.
48
Schmitt-Grohe and Uribe (2005) include capital in their model and assume that profits and wage income are taxed at
the same rate.
49
For example, Burstein and Hellwig (2008) argue that models with Calvo pricing “substantially overstate” the welfare
cost of price dispersion. According to their calibration of a menu cost model, relative price distortions do not
contribute much (compared to the opportunity cost of holding money) when they quantify the welfare effects of
inflation.