This paper examines optimal monetary policy in an open-economy two-country model with sticky prices. We show that currency misalignments are inefficient and lower world welfare. We find that optimal policy must target not only inflation and the output gap, but also the currency misalignment....

The traditional case for flexibility in nominal exchange rates assumes that there is nominal price stickiness that prevents relative prices from adjusting in response to real shocks. When prices are sticky in producers' currencies, nominal exchange rate changes can achieve the relative price...