The NEP-OPM Blog

September 27, 2009

This blog is an experiment to explore the feasibility of scientific discussion on an Economics blog. NEP-OPM disseminates every week new working papers in the field of Open Macroeconomics. Among them, the NEP-OPM editor selects one to be discussed. Everyone is invited to comment. Try to stay civil, or your comments will be removed. And encourage others to read or join in the discussion.


Monetary Policy and Trade Globalization

May 10, 2010

by Dudley Cooke

I develop a two country general equilibrium model with heterogeneous price-setting firms to understand how shocks to monetary policy and aggregate labor productivity impact trade integration, which I capture through the (inverse) average productivity of exporting firms. A contractionary domestic monetary policy shock raises the average productivity of domestic exporting firms but lowers the average productivity of foreign exporting firms. The magnitude of these changes is greater when governments target domestic price inflation as opposed to consumer price inflation. A positive shock to domestic labor productivity generates positive – although quantitatively small – changes in the average productivity of all exporting firms when consumer price inflation is targeted. When domestic price inflation is targeted, the same shock causes a fall in the average productivity of domestic exporting firms, and a far larger rise in the productivity of foreign exporting firms.

The author allows monetary policy shocks to influence heterogeneous firm export decisions in a model setting a-la Melitz (2003). Fixed costs of exporting shrink following a contractionary monetary policy due to the inflation decline. More firms export, which drives up their wage bill and consequently their marginal costs. This causes re-allocation (only the most productive firms continue to export) and increases the average productivity of exporters. The transmission mechanism is interesting but in reality may operate at longer time horizons than those proposed by the author. How quickly do monetary policy decisions lead to lower inflation rates and, consequently, lower export costs that cause the resource reallocation?

Leverage Constraints and the International Transmission of Shocks

May 2, 2010

by Michael B. Devereux and James Yetman

Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage-constrained financial institutions. In the absence of leverage constraints, international portfolio diversification has no implications for macroeconomic co-movements. When leverage constraints bind, however, the presence of diversified portfolios in combination with these constraints introduces a powerful financial transmission channel which results in a high correlation among macroeconomic aggregates during business cycle downturns, quite independent of the size of international trade linkages.

Devereux and Yetman extend Krugman’s (2008) partial equilibrium “international financial multiplier” into a full-blown general equlibrium model. When leverage constraints bind, business cycle shocks propagate strongly across countries through inter-connected balance sheets. A fall in asset values in one country leads to asset sales in another country, thus propagating the asset price drop. The asset sales force borrowing reductions (leverage constraints bind), which have negative real effects in all countries. The adverse effects are magnified by the price drop feedback loop. It would be interesting to see how this result evolves in a more complete framework where trade provides alternative means of diversification.

International Risk Sharing: Through Equity Diversification or Exchange Rate Hedging?

October 28, 2009

by Charles Engel and Akito Matsumoto

Well-known empirical puzzles in international macroeconomics concern the large divergence of equilibrium outcomes for consumption across countries from the predictions of models with full risk sharing. It is commonly believed that these risk-sharing puzzles are related to another empirical puzzle-the home-bias in equity puzzle. However, we show in a series of dynamic models that the full risk sharing equilibrium may not require much diversification of equity portfolios when there is price stickiness of the degree typically calibrated in macroeconomic models. This conclusion holds under a range of assumptions about home bias in preferences, price setting as PCP or LCP, and with or without nominal wage stickiness as long as there is some price rigidity.

The authors show that Cole and Obstfeld (1991) result that terms of trade adjustments provide for the majority of the risk-sharing benefits is only true when prices are flexible. In a log-linearized version of a two-country DSGE model with sticky prices, trade in only equities achieves complete risk sharing. For many parametrizations, households are long on home equity and short on foreign equity, so that an unexpected currency depreciation which has positive income effects under sticky prices is offset by a negative wealth shock to the portfolio. As with the results of, e.g., Devereux and Sutherland (2008), it may be interesting to see the implications of inefficient portfolio selection due to imperfect information, uncertainty, etc.

Estimating the border effect: some new evidence

October 18, 2009

by Gita Gopinath, Pierre-Olivier Gourinchas, Chang-Tai Hsieh, Nicholas Li

To what extent do national borders and national currencies impose costs that segment markets across countries? To answer this question the authors use a dataset with product-level retail prices and wholesale costs for a large grocery chain with stores in the United States and Canada. They develop a model of pricing by location and employ a regression discontinuity approach to estimate and interpret the border effect. They report three main facts: One, the median absolute retail price and wholesale cost discontinuities between adjacent stores on either side of the U.S.-Canadian border are as high as 21 percent. In contrast, within-country border discontinuity is close to 0 percent. Two, the variation in the retail price gap at the border is almost entirely driven by variation in wholesale costs, not by variation in markups. Three, the border gaps in prices and costs co-move almost one-to-one with changes in the U.S.-Canadian nominal exchange rate. They show these facts suggest that the price gaps they estimate provide only a lower bound on border costs.

The authors build a two-country model of horizontal differentiation based on Salop’s (1979) circular city model in which degree of segmentation is endogenous and depends on the sizes of countries, distance from the border and substitutability across locations. The model itself provides numerous novel predictions and can account for a number of properties of prices across borders. The authors then discontinuity regression approach on a scanner price dataset of a large US & Canadian retailer to document how the model can match several interesting properties of prices across borders. A very interesting contribution.

Globalization and Individual Gains from Trade

September 27, 2009

by Kristian Behrens and Yasusada Murata

We analyze the impact of globalization on individual gains from trade in a general equilibrium model of  monopolistic competition featuring product diversity, procompetitive effects and income heterogeneity between and within countries. We show that, although trade reduces markups in both countries, its impact on variety depends on their relative position in the world income distribution: product diversity in the lower income country always expands, while that in the higher income country may shrink. When the latter occurs, the richer consumers in the higher income country may lose from trade because the relative importance of variety versus quantity increases with income. We illustrate this effect using data on GDP per capita and population for 186 countries, as well as parameter estimates for domestic income distributions. Our results suggest that U.S. trade with countries of similar GDP per capita makes all agents in both countries better off, whereas trade with countries having lower GDP per capita may adversely affect up to 11% of the U.S. population.

In a framework that allows decomposition of gains from trade into those due to product diversity and due to pro-competition effects, Behrens and Murata show that product diversity always expands with trade in poor countries (may shrink in rich countries), and that trade always improves competition. Consequently, everyone in poor countries must gain, while there may be situations when some rich citizens of rich countries lose from trade because they value loss of diversity more than gain in efficiency.

It would be interesting to see how the results change if comparative advantage and two productive factors are introduced into the model’s framework. It would also be interesting to get a sense of the extent to which assumed variable elasticity of substitution (with income) is an empirically relevant modeling strategy.