Working Paper: CEPR ID: DP14952
Authors: Matteo Cacciatore; Fabio Ghironi
Abstract: We study how trade linkages affect the conduct of monetary policy in a two-country model with heterogeneous firms, endogenous producer entry, and labor market frictions. We show that the ability of the model to replicate key empirical regularities following trade integration---synchronization of business cycles across trading partners and reallocation of market shares toward more productive firms---is central to understanding how trade costs affect monetary policy trade-offs. First, productivity gains through firm selection reduce the need of positive inflation to correct long-run distortions. As a result, lower trade costs reduce the optimal average inflation rate. Second, as stronger trade linkages increase business cycle synchronization, country-specific shocks have more global consequences. Thus, the optimal stabilization policy remains inward looking. By contrast, sub-optimal, inward-looking stabilization---for instance too narrow a focus on price stability---results in larger welfare costs when trade linkages are strong due to inefficient fluctuations in cross-country aggregate demand.
Keywords: trade integration; optimal monetary policy
JEL Codes: E24; E32; E52; F16; F41; J64
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| High trade costs and weak trade linkages (F12) | Positive inflation stimulates job creation (E31) |
| Lower trade costs (F19) | Reduced inflation targets (E31) |
| Stronger trade linkages (F19) | Increased business cycle synchronization (F44) |
| Increased business cycle synchronization (F44) | Country-specific shocks have more pronounced global consequences (F41) |
| Stronger trade linkages (F19) | Larger welfare costs from suboptimal inward-looking stabilization policies (D69) |