Trade, unemployment, and monetary policy

We study how trade linkages affect the conduct of monetary policy in a two-country model with heterogeneous firms, endogenous producer entry, and labor market frictions. We show that the ability of the model to replicate key empirical regularities following trade integration—synchronization of business cycles across trading partners and reallocation of market shares toward more productive firms—is central to understanding how trade costs affect monetary policy trade-offs. First, productivity gains through firm selection reduce the need for positive inflation to correct long-run distortions. As a result, lower trade costs reduce the optimal average inflation rate. Second, as stronger trade linkages increase business cycle synchronization, country-specific shocks have more global consequences. Thus, the optimal stabilization policy remains inward looking. By contrast, sub-optimal, inward-looking stabilization—for instance too narrow a focus on price stability—results in larger welfare costs when trade linkages are strong due to inefficient fluctuations in cross-country aggregate demand.