No. 214 - Monetary Coordination under an Exchange Rate Agreement and the Optimal Monetary Instrument

This paper analyses the choice of the monetary instrument in a stochastic two-country setting, where exchange rate stability is maintained through the coordination of monetary policies. When shocks to the real exchange rate are significant, the optimal monetary instrument is sensitive to the importance attached to area- wide, as opposed to national, stabilisation objectives. An increase in the weight of area-wide objectives or in the degree of trade integration between the two countries is shown to entail a shift of the optimal monetary instrument towards interest rate pegging. In the ERM context, this result implies that the anchor country should interpret monetary targets more flexibly as a consequence of the increased disturbances affecting its money demand as well as of the prospective increase in the degree of trade integration within the Community and of the greater emphasis on Community-wide considerations associated with the progress towards EMU. The rise of significant phenomena of currency substitution might lead to the adoption of an area-wide monetary instrument, which, instead, is invariant to the balance between area-wide and national stabilisation objectives. In this case the adoption of monetary control at the area level would entail the mutually beneficial decline of the role of one country in the ERM as the anchor.