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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

  • Alexander Mihailov

    ()

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 University of Essex, Department of Economics in its series Economics Discussion Papers with number 567.

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Date of creation: 28 Oct 2003
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Handle: RePEc:esx:essedp:567
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