Monetary Policy Rules in an Interdependent World

This Paper analyses the welfare effects of monetary policy rules in a quantitative business cycle model of a two-country world. The model features staggered price setting, and shocks to productivity and to the uncovered interest rate parity (UIP) condition. UIP shocks have a sizable negative effect on welfare, when trade links are strong. An exchange rate peg may raise world welfare, if the peg eliminates the UIP shocks. The model explains the empirical finding that more open economies are more likely to adopt a peg.