Optimal Monetary Policy in a Currency Union with Interest Rate Spreads

We introduce \u85 nancial imperfectionsasymmetric net wealth positions, incomplete risk-sharing, and interest rate spread across member countries in a prototypical two-country currency union model and study implications for monetary policy transmission mechanism and optimal pol-icy. In addition to, and independent from, the standard transmission mechanism associated with nominal rigidities, \u85 nancial imperfections introduce a wealth redistribution role for monetary policy. Moreover, the two mechanisms reinforce each other and amplify the e¤ects of monetary policy. On the normative side, \u85 nancial imperfections, via interactions with nominal rigidities, generate two novel policy trade-o¤s. First, the central bank needs to pay attention to distribu-tional e ¢ ciency in addition to macroeconomic (and price level) stability, which implies that a strict ination targeting policy of setting union-wide ination to zero is never optimal. Second, the interactions lead to a trade-o ¤ in stabilizing relative consumption versus the relative price gap (the deviation of relative prices from their e ¢ cient level) across countries, which implies that the central bank allows for less exibility in relative prices. Finally, we consider how the central bank should respond to a \u85nancial shock that causes an increase in the interest rate spread. Unde