The gain from commitment in a two-country economy with inflation persistence

•This paper investigates optimal monetary policy in a two-country economy with inflation persistence.•We assume that a fraction of producers in each country set their prices based on a rule of thumb.•Large gains from commitment exist when backward-looking inflation dominates inflation dynamics in each country.•The source of large gains from commitment is associated with the presence of a deflationary bias.

In recent years, the worldwide inflation rate appears to be converging to a low stable level. Moreover, the Phillips curve is flattening in many countries. These facts indicate that the output gap fluctuations associated with inflation persistence in one country influence other countries and suggest that the central bank consider the effect of inflation persistence on the real economy in an open economy framework. The objective of this paper is to explore optimal monetary policy in a two-country economy with inflation persistence. To consider the case in which inflation persistence is present in both countries, we assume that a fraction of firms that change their prices follows the rule-of-thumb pricing rule. In this case, the new Keynesian Phillips curve (NKPC) in each country becomes flatter as the fraction of firms employing the rule-of-thumb pricing rule increases in both countries. Our results show gains from commitment in a two-country economy with inflation persistence. This paper addresses that the presence of a severe deflationary bias is the main source of the large gain from a commitment policy in a two-country economy with inflation persistence.