To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jmoneco.2004.06.002 Byline: Giancarlo Corsetti (a)(b)(c), Paolo Pesenti (c)(d)(e) Abstract: This paper provides a baseline general equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities. An inward-looking policy of domestic price stabilization is not optimal when firms' markups are exposed to currency fluctuations. Such a policy raises exchange rate volatility, leading foreign exporters to charge higher prices vis-a-vis increased uncertainty in the export market. As higher import prices reduce the purchasing power of domestic consumers, optimal monetary rules trade off a larger domestic output gap against lower consumer prices. Optimal rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a non-monotonic way to the degree of exchange rate pass-through. Author Affiliation: (a) European University Institute, 50133 Florence, Italy (b) University of Rome III, Rome, Italy (c) CEPR, London EC1V 7RR, UK (d) Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045, USA (e) NBER, Cambridge, MA 02138, USA Article Note: (footnote) [star] We thank the editor and the anonymous referee, as well as Pierpaolo Benigno, Caroline Betts, Luca Dedola, Charles Engel, Gianluca Femminis, Mark Gertler, Luigi Guiso, Luisa Lambertini, Ken Rogoff, Lars Svensson, and Cedric Tille for useful suggestions. We have benefited from comments by seminar participants at the ASSA meeting, NBER Summer Institute, Bank of Italy, Boston College, INSEAD, MIT, NYU, Yale, and the Universities of Aarhus, Copenhagen, Milan, Tilburg, Warwick, and Wisconsin Madison. We also thank Raymond Guiteras and Kathryn Vasilaky for excellent research assistance. Corsetti's work on this paper is part of a research network on 'The Analysis of International Capital Markets: Understanding Europe's Role in the Global Economy,' funded by the European Commission under the Research Training Network Programme (Contract No. HPRN-CT-1999-00067). The views expressed here are those of the authors, and do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve System, or any other institution with which the authors are affiliated.