2. Related Literature
al. (2006).
• Simulated cost-push as well as monetary policy shocks, which are assumed to be country-specific,
also have a negative impact on domestic and foreign output since both economies are interdepen-
dent due to terms-of-trade externalities.
• In contrast to Corsetti/Pesenti (2001), expansionary monetary policy shocks always have a
”prosper thyself” and ”beggar thy neighbor” effect since they influence the terms of trade benefi-
cially for the home (foreign) country’s resident households by decreasing them below (raising them
above) their zero-inflation steady-state value. In addition, this effect would induce a rise of both
domestic and foreign output above their flexible-price values.
• If the ECB implemented the interest-rate rule proposed in the present article, it would encounter
lower fluctuations in European producer price inflation compared to an interest-rate rule as proposed
for the Fed. This is consistent with the ECB’s paramount ob jective of price stability. However, this
advantage only holds at the expense of relatively high fluctuations in the European output gap; a
trade-off commonly observed in literature on monetary policy.
The remainder of this article is structured as follows: Section 2 gives a short review of current literature
on the topic, Section 3 outlines the basic discrete-time, two-country DSGE model, Section 4 presents
the equilibrium conditions on all markets under flexible prices, Section 5 introduces the New Keynesian
framework, and Section 6 derives a locally unique rational expectations equilibrium for a calibrated
version of the model. The analysis is completed by an impulse-response analysis in Section 7. Finally,
Section 8 concludes. Lengthy derivations are given in respective appendices.
2. Related Literature
In general, the present article can be embedded in the so-called New Open Economy Macroeconomic liter-
ature pioneered by Obstfeld/Rogoff (1995), which has been enriching the traditional Open Economy
Macroeconomic literature by its rigorous microeconomic foundation. There has been done a lot of re-
search on this topic so far and it seems to continue to appeal to a wide range of scholars. There are quite
numerous survey articles and survey book chapters on this issue, e.g., Obstfeld/Rogoff (1996, chapter
10), Lane (2001), Engel (2002), Waish (2003, chapter 6), or Gall (2008, chapter 7). Of course, this
parsimonious overview remains incomprehensive.
In particular, the present paper deals with a two-country DSGE model such that it is noteworthy to briefly
summarize the content of similar articles besides Obstfeld/Rogoff (2001) and Corsetti/Pesenti
(2001) such as, e.g., Clarida et al. (2002), Pappa (2004), or Benigno/Benigno (2006).
• Clarida et al. (2002) investigate whether there are gains from cooperation between two monetary
authorities in case of discretionary monetary policy. The authors find that in case of non-cooperation
the structure of the policy problem is isomorphic to the closed-economy case. Unless there is loga-
rithmic utility of consumption, there are gains from monetary policy cooperation as the optimizing
monetary authorities are willing to internalize possible spill-over effects from the terms of trade.
• Pappa (2004) finds that for the case of central banks that are committed to their policy rules there
are no gains from cooperation for the special parameter constellation, for which the cooperative
and non-cooperative regimes coincide, since in this case independent central banks would not face
any spill-over effects from the terms of trade. For this parameter constellation a monetary union
is clearly suboptimal as the supranational authority cannot replicate the first-best allocation when
the nominal exchange rate is fixed. For any other parameter constellations, however, there may be
welfare losses from deviating from the cooperation benchmark.