Price Stability with Imperfect Financial Integration∗

This paper evaluates the welfare implications of monetary policy rules when international financial markets are incomplete. Using a two-country dynamic general equilibrium monetary model, we evaluate the magnitude of the costs of imperfect risk sharing. Under a price stability policy in both countries, they are in the range of 0.07-0.70 percent of a permanent shift in steady-state consumption. These costs are significant, possibly even higher than the costs induced by the volatility of the business cycle, as found by Lucas (1987). Most important, we find that with non-zero holdings of net foreign assets, there exist non-negligible gains from following a coordinated monetary policy instead of a price-stability policy. These gains are in the range of 0.01-0.10 percent of a permanent shift in steady-state consumption. ∗I am grateful for helpful discussions and comments to Alberto Bisin, Gianluca Benigno, Matthew Canzoneri, Behzad Diba, Martin Evans, Mark Gertler, Mike Woodford, and seminar partecipants at Georgetown and NYU. Anita Tuladhar has provided excellent research assistance.