Exchange rate volatility and cooperation in an incomplete markets' economy

In this paper, we contribute to the debate on whether exchange rate volatility is detrimental or not for welfare by characterizing optimal monetary policies in a two-country OLG model where markets are incomplete. The equilibrium nominal exchange rate is volatile as a result of shocks against which agents are not able to insure. In a non-cooperative environment, central banks have an incentive to devaluate the domestic currency by giving monetary transfers to domestic agents. However, such policies result in higher exchange rate volatility. We show that cooperation reduces exchange rate volatility as: (1) the negative spillover effects due to the expansionary monetary policies are internalized; (2) cooperative policies smooth the effects of shocks to fundamentals on the exchange rate. For standard parameter values, the gains from cooperation are not negligible. However, for cooperation to be Pareto improving countries should be weighted differently in the social welfare function. This could explain the lack of cooperation across countries, instead of the negligible gains as previously argued.