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Trade and Optimal Monetary Policy

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  • Federico Ravenna

    (University of California Santa Cruz)

  • Giovanni Lombardo

    (European Central Bank)

Abstract

Using a stochastic business cycle model of a small open economy we ask how the problem of the optimizing policy-maker changes endogenously as the international trade structure is altered. From input-output data for OECD and emerging market economies, we document that differences in trade across countries are substantial, and that the composition of trade varies as much as openness to trade. The trade and production structures examined in our theoretical model easily map into measurable macroeconomic characteristics of countries. Our results are as follows. First, the traditional imports to GDP ratio turns out to be close to irrelevant for the ranking of monetary policies. Second, the composition of imports has a very substantial impact on welfare. Given the same degree of openness, the exchange rate peg is more inefficient if the bias towards non-tradable goods is high, and less inefficient if the share of imported intermediates is low. That is, open countries engaging in much vertical trade find it more costly to peg the exchange rate. Third, while a stylized regularity of emerging market economies is the very high share of imported capital goods, compared with industrial countries, this turns out to have no impact on the welfare result. Fourth, local currency pricing has a muted impact . This is the consequence of two assumptions: the existence of a long chain of substitutability in demanded goods, and the mobility of labor across sectors, so that imported inputs affect factor prices in all sectors directly, rather than through general equilibrium effects.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 784.

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Date of creation: 2009
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Handle: RePEc:red:sed009:784

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  1. Bruno Merlevede & Joseph Plasmans & Bas van Aarle, 2003. "A Small Macroeconomic Model of the EU-Accession Countries," Open Economies Review, Springer, vol. 14(3), pages 221-250, July.
  2. Maurice Obstfeld & Kenneth Rogoff, 1999. "New Directions for Stochastic Open Economy Models," NBER Working Papers 7313, National Bureau of Economic Research, Inc.
  3. Cook, David & Devereux, Michael B., 2006. "Accounting for the East Asian Crisis: A Quantitative Model of Capital Outflows in Small Open Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(3), pages 721-749, April.
  4. Rudolfs Bems, 2008. "Aggregate Investment Expenditures on Tradable and Nontradable Goods," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 852-883, October.
  5. Christoph Fischer, 2004. "Real currency appreciation in accession countries: Balassa-Samuelson and investment demand," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 140(2), pages 179-210, June.
  6. Lavan Mahadeva & Katerina Smidkova, 2004. "Modelling transmission mechanism of monetary policy in the Czech Republic," Macroeconomics 0402032, EconWPA.
  7. Coricelli, Fabrizio & Jazbec, Bostjan & Masten, Igor, 2003. "Exchange Rate Pass-Through in Candidate Countries," CEPR Discussion Papers 3894, C.E.P.R. Discussion Papers.
  8. Balázs Égert & Imed Drine & Kirsten Lommatzsch & Christophe Rault, 2002. "The Balassa-Samuelson effect in Central and Eastern Europe: Myth or reality?," William Davidson Institute Working Papers Series 483, William Davidson Institute at the University of Michigan.
  9. Attila Csajbók (ed.) & Ágnes Csermely (ed.), 2002. "Adopting the euro in Hungary: expected costs, benefits and timing," MNB Occasional Papers 2002/24, Magyar Nemzeti Bank (the central bank of Hungary).
  10. Tomás Holub & Martin Cihák, 2001. "Convergence of Relative Prices and Inflation in Central and Eastern Europe," IMF Working Papers 01/124, International Monetary Fund.
  11. Kollmann, Robert, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," Journal of International Economics, Elsevier, vol. 55(2), pages 243-262, December.
  12. Nikolay Nenovsky & Kalina Dimitrova, 2002. "Dual Inflation Under the Currency Board: The Challenges of Bulgarian EU Accession," William Davidson Institute Working Papers Series 487, William Davidson Institute at the University of Michigan.
  13. Egert, Balazs, 2002. "Estimating the impact of the Balassa-Samuelson effect on inflation and the real exchange rate during the transition," Economic Systems, Elsevier, vol. 26(1), pages 1-16, April.
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