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Productivity shocks and monetary policy in a two-country model

Author

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  • Jang, Tae-Seok
  • Okano, Eiji

Abstract

In this paper, we examine the effects of foreign productivity shocks on monetary policy in a symmetric open economy. Our two-country model incorporates the New Keynesian features of price stickiness and monopolistic competition based on the cost channel of Ravenna and Walsh (2006). In particular, in response to asymmetric productivity shocks, firms in one country achieve a more efficient level of production than those in another economy. Because the terms of trade are directly affected by changes in both economies’ output levels, international trade creates a transmission channel for inflation dynamics in which a deflationary spiral in foreign producer prices reduces domestic output. When there is a decline in economic activity, the monetary authority should react to this adverse situation by lowering the key interest rate. The impulse response function from the model shows that a productivity shock can cause a real depreciation of the exchange rate when economies are closely integrated through international trade.

Suggested Citation

  • Jang, Tae-Seok & Okano, Eiji, 2013. "Productivity shocks and monetary policy in a two-country model," Dynare Working Papers 29, CEPREMAP.
  • Handle: RePEc:cpm:dynare:029
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    Keywords

    cost channel; new Keynesian model; productivity shocks; terms of trade; two-country model;

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs

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