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When and How Much Does a Peg Increase Trade? The Role of Trade Costs and Import Demand Elasticity under Monetary Uncertainty

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  • Alexander Mihailov

Abstract

This paper extends stochastic research in new open-economy macroeconomics (NOEM) to study the effects of the exchange-rate regime on international trade in a more realistic, yet rigorous, analytical set-up. We essentially incorporate "iceberg" costs, inducing home bias, into a unified framework which nests trade between countries that produce similar vs. different composite goods. Our main result is that given (some degree of) producer's currency pricing with symmetry in structure and money shock distributions as the only source of uncertainty, a fixed exchange rate slightly reduces expected trade, measured as a share in GDP, relative to a float under elastic import demand, i.e. when countries' output mixes are similar; inelastic import demand, possible under the same taste for diversity but far less substitutable national outputs arising in our model from differences in endowments although not in technological labor input requirements, reverses this conclusion. What a peg can achieve in any of these cases is trade stabilization (across states of nature). It would be greater for (symmetric) nations which (i) have a larger proportion of producer's currency pricing in their trade, (ii) are exposed to higher monetary uncertainty, (iii) produce less substitutable output mixes and (iv) are located closer to one another or apply weaker bilateral trade restrictions.

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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 122247000000000203.

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Date of creation: 27 May 2004
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Handle: RePEc:cla:levrem:122247000000000203

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Cited by:
  1. Alexander Mihailov, 2003. "Effects of the Exchange-Rate Regime on Trade under Monetary Uncertainty: The Role of Price Setting," Economics Discussion Papers, University of Essex, Department of Economics 566, University of Essex, Department of Economics.
  2. Alexander Mihailov, 2004. "The Empirical Range of Pass-Through in US, German and Japanese Macrodata," Money Macro and Finance (MMF) Research Group Conference 2004, Money Macro and Finance Research Group 44, Money Macro and Finance Research Group.
  3. Alexander Mihailov, 2003. "Exchange Rate Pass-Through on Prices in Macrodata: A Comparative Sensitivity Analysis," Economics Discussion Papers, University of Essex, Department of Economics 568, University of Essex, Department of Economics.

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