Implications of Exchange Rate Pass-Through and Nontradable Goods for International Policy Cooperation

This paper investigates the welfare consequences of international policy cooperation by simultaneously introducing the following three elements in a standard two-country general equilibrium model: (i) general degrees of exchange rate pass-through, (ii) nontradable goods and their sector-specific productivity shocks, and (iii) general weights on goods in Cobb-Douglas consumption indices. There are two channels for possible mutual welfare gains from policy cooperation: First, cooperation can compensate for insufficient changes in the terms of trade when the degree of exchange rate pass-through is intermediate. Second, countries can cooperate in reaction to shocks in the nontradable goods sectors. This second channel is revealed by deriving an analytical condition for welfare gains under full pass-through and this condition is characterized by the weights in the consumption indices and the variances of sector-specific productivity shocks. Numerical evaluation demonstrates that when the two countries are symmetric and equal weights on consumption goods are assumed, welfare gains from cooperation increase as symmetric pass-through elasticity increases, which implies that the second channel dominates the first, whose effect on welfare gains is nonmonotonic in pass-through elasticity.