What is the optimal design of monetary policy in open economies? From the most recent debate it is far from
clear that monetary policy in open economies should have any international dimen-
sion at all. Several writers including Clarida, Gali and Gertler (2002), Gali and
Monacelli (2005) and Obstfeld and Rogoff (2002) make a strong case in favor of
an inward-looking monetary policy. The baseline of these
studies is that international integration in goods and financial markets decreases
the need to take account of macroeconomic developments abroad when deciding
about the optimal monetary policy stance.
The debate in the literature on optimal monetary policy in times of highly
integrated goods and financial markets is far from settled. The optimal choice of the
monetary policy target, the weight assigned to external factors in monetary policy
decisions and the question, which simple, i.e. non-optimal, targeting rule can best
support the efficient resource allocation belong to the issues that are controversially
discussed. Employing a stochastic general equilibrium framework of the New Keynesian
type, this paper addresses these questions by accounting for an important change
in the nature of international cross-country linkages brought about by globalization
(see Hummels, Ishii and Yi (2001) and Yi (2003)). The production sequence of final
consumption goods increasingly stretches across many countries and is associated
with vertical trade. In the light of these changes, the interdependence of countries is
increasingly based on trade along vertical production chains.
We further suppose that the
degree of pass-through for consumption goods prices may be less than complete. As
in Sutherland (2005), both productivity and cost-push shocks are considered. World
aggregate welfare is maximized when monetary policy responds to both types of
shocks irrespective of whether they originate at home or abroad.
Optimal monetary rules, however, involve very demanding information require-
ments that may prevent their practical implementation. We therefore go on to ask
which simple targeting rule comes closest in welfare terms to the optimal rule. Sim-
ple rules are interpreted as a guideline to assess policy options and
prepare policy decisions. The results hinge
critically on the degree of the cross-country vertical integration in production and
the relative importance of productivity and cost-push shocks. A numerical example
is used to analyze and discuss the welfare implications of the simple targeting rules
under consideration.

The relative volatility of productivity and cost-push shocks determines whether
variables such as nominal income and the money supply or price indices such as
producer or consumer prices should be used as the monetary policy objective. The
degree of vertical integration, however, is decisive for the welfare ranking of the price
targeting rules. Generally, nominal income targeting and monetary targeting fare
better than producer price and consumer price targeting in the presence of compar-
atively strong cost-push shocks. A strict targeting of price indices comes closest to
the welfare-maximizing policy if productivity shocks are much more important than
cost-push shocks. This has been stressed by Sutherland (2005) before. Our welfare
comparison of price targeting rules does not corroborate the conclusion referred to
above that the producer price index is the optimal choice of a monetary policy target
in an open economy. For a wide range of parameter values a policy of CPI targeting
is superior to producer price targeting.