Consumer Search, Incomplete Exchange Rate Pass-Through and Optimal Interest Rate Policy

Abstract

This paper studies utility-maximizing monetary policy in a two-country economy with consumer search frictions. Search frictions provide a micro-foundation for incomplete exchange rate pass-through and international deviations from the law of one price. I show that optimal interest rate policy targets deviations from the law of one price and acts to mitigate the effect of search frictions. In a quantitative setting, with internationally correlated technology and preference shocks, optimal policy generates positive cross-country correlation of nominal interest rates.