Monetary Stabilization of Export Shocks, Revisited

We study how monetary policy shapes macroeconomic outcomes in a two-sector small open economy hit by export shocks — due, e.g., to export tariffs, geopolitical tensions, or a recession in destination countries — allowing the shock to have both aggregate and distributional effects. Imperfect worker mobility across sectors, coupled with incomplete markets against aggregate and idiosyncratic shocks, implies that export contractions (i) spill over across sectors due to households’ precautionary response and (ii) affect income and consumption inequalities within and across sectors — in addition to their usual asymmetric effects on sectoral outputs and wages. In this context, exchange-rate flexibility provides insurance against inefficient fluctuations in consumption inequality, which increases the social value of floating-rate regimes. Relative to a nominal exchange-rate peg, flexible inflation targeting helps mitigate the rise in consumption inequality after an export contraction, especially among tradable-sector workers. However, even flexible inflation targeting does not, in general, provide sufficient exchange-rate flexibility relative to the optimal monetary policy.