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Industrial Structure and Monetary Policy in a Small Open Economy

  • Thomas Lubik

In standard New Keynesian models, the size of the output expansion generated by aggregate demand shocks depends crucially on the elasticity of labor supply which is empirically quite small. In principle, this link can be broken in a multisectoral economy with differing degrees of price stickiness, so that the required increase in labor supply can come from other sectors. This paper reinterprets this line of reasoning in a small open economy with a traded and a non-traded sector. The latter is characterized by monopolistic competition and nominal price stickiness. The main findings of the paper are twofold. It is shown that, in fact, the size of the labor supply elasticity has no significant effect on the output response to a monetary policy shock. Yet, in this open economy framework the puzzle of the output response remains since they occur only for unrealistically high intertemporal substitution elasticities. Furthermore, it is shown that the current account response to an expansionary monetary shock crucially depends on the industrial structure of the money and not, as previously claimed, on consumption preferences alone. For reasonable model specifications the current acount moves into deficit.

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Paper provided by The Johns Hopkins University,Department of Economics in its series Economics Working Paper Archive with number 493.

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Date of creation: Jan 2003
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Handle: RePEc:jhu:papers:493
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  1. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
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  4. David Dixon, Huw & Thustrup Hansen, Claus, 1999. "A mixed industrial structure magnifies the importance of menu costs," European Economic Review, Elsevier, vol. 43(8), pages 1475-1499, August.
  5. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-20, September.
  6. Robert Feenstra & Paul Bergin, 2003. "Pricing To Market, Staggered Contracts, And Real Exchange Rate Persistence," Working Papers 991, University of California, Davis, Department of Economics.
  7. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  8. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
  9. Olivier Jeanne, 1997. "Generating Real Persistent Effects of Monetary Shocks: How Much Nominal Rigidity Do We Really Need?," NBER Working Papers 6258, National Bureau of Economic Research, Inc.
  10. Lilia Cavallari, 1999. "Current account and exchange rate dynamics," Working Papers 38, University of Rome La Sapienza, Department of Public Economics.
  11. Lane, Philip R., 1997. "Inflation in open economies," Journal of International Economics, Elsevier, vol. 42(3-4), pages 327-347, May.
  12. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
  13. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  14. Dornbusch, Rudiger, 1983. "Real Interest Rates, Home Goods, and Optimal External Borrowing," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 141-53, February.
  15. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May.
  16. Hau, Harald, 2000. "Exchange rate determination: The role of factor price rigidities and nontradeables," Journal of International Economics, Elsevier, vol. 50(2), pages 421-447, April.
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