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.