Price Stability with Imperfect Financial Integration

This paper evaluates the welfare implications of policy rules when international financial markets are incomplete. Using a two-country dynamic general equilibrium model with incomplete markets, price stickiness and monopolistic competition, one finds that an allocation in which the producer inflation rates in both countries are stabilized to zero reproduces the flexible-price allocation. However, this allocation is sub-optimal with deadweight losses evaluated around 0.05 percent of a permanent shift in steady-state consumption. A state-contingent producer inflation policy is the feasible first-best. But, the gains from pursuing this policy instead of price stability are small in terms of reduction in the deadweight losses. Therefore, under incomplete markets, price stability is a good approximation of the feasible first best policy