Firms integration strategies and the international business cycle

Transcription

1 Firms inegraion sraegies and he inernaional business cycle Lilia Cavallari Universiy of Rome III Absrac This paper provides a framework for he analysis of rms inegraion sraegies ha incorporaes he endogenous deerminaion of he number of rms ha serve foreign markes hrough expors and he number of mulinaional rms ha raher engage in horizonal foreign direc invesmens. We nd ha rms inegraion sraegies play a key role in propagaing produciviy and moneary policy shocks. In addiion, we show ha accouning for mulinaional sales along wih rade allows o shed ligh on a number of puzzling feaures in erms of rade and exchange rae daa. Di erences in rms inegraion sraegies can accoun for persisen deviaions from he purchasing power pariy and he lack of a secular deerioraion in he erms of rade of counries wih lower produciviy. In our seup wih endogenous inegraion sraegies, we nally show ha moneary sabilisaion migh Lilia Cavallari, Universiy of Rome III, Diparimeno di Isiuzioni, Economia e Socieà, Via C. Chiabrera, 93, 45 Rome, Ialy, cavallar@eco.uniroma3.i. The auhor hanks wo anonymous referees for very helpful commens. The usal disclaimer applies.

2 involve a policy rade-o beween he desire o smooh ucuaions in producers prices and he need o faciliae adjusmens in consumers prices.. Keywords: mulinaional rms, foreign direc invesmens, rm enry, inernaionalised producion, moneary policy, inernaional business cycle JEL codes: F4 Inroducion This paper provides a framework for he analysis of rms inegraion sraegies ha incorporaes he endogenous deerminaion of he number of rms ha serve foreign markes hrough expors and he number of mulinaional rms ha raher engage in horizonal foreign direc invesmens. Our aim is o invesigae how di erences in rms inegraion sraegies a ec he way produciviy and moneary policy shocks spread heir e ecs worldwide. The analysis focuses on fricions in inernaional goods markes as represened by cosly rade and local sales by mulinaional rms. The emphasis on rade fricions is moivaed by he well-documened fac ha despie he secular endency owards falling rade and ranspor coss, segmenaion in inernaional goods markes remains remarkably high. Moreover, he volume of sales by a liaes of mulinaional enerprises has grown remendously in he pas wo decades, even oupacing he noiceable expansion of rade in manufacures ha has occurred in he period. The mode of foreign marke access has araced a growing aenion in he rade lieraure, wih a number of recen conribuions focusing on he deerminans of enry behaviour by mulinaional rms. Much less aenion Recen conribuions ha examine he choice of foreign marke access include, among 2

3 has been devoed o he macroeconomic implicaions of di eren modes of serving foreign markes. Recen aemps in his direcion have invesigaed several dimensions in which mulinaional aciviies can conribue o our undersanding of he inernaional business cycle and he role of moneary policy in a globalised world. 2 A common drawback in mos of hese analyses is he lack of an explici microeconomic foundaion for he decision o go mulinaional. This paper lls he gap by examining he deerminans of rade and horizonal foreign direc invesmens in a model where enry in foreign markes is endogenous. 3 The paper models a sylized wo-counry world economy characerised by monopoly disorions and price sickiness in he radiion of he new open economy macroeconomics. In our seup, each rm decides wheher o expor is producs or inves in a producion faciliy overseas, becoming a mulinaional enerprise. As usual in models wih endogenous enry, choosing beween rade and foreign direc invesmens requires o srike a balance beween xed and variable coss. Inernaional rade involves a xed cos of paricipaing in he expor marke as well as a variable ranspor cos, many ohers: Helpman, Méliz and Yeaple (25) for a model ha incorporaes horizonal FDI and rade, Yeaple (23) and Aizenman and Marion (24) for he choice beween horizonal and verical FDI and Anràs and Helpman (24) for he ousourcing alernaive. Helpman (26) provides a comprehensive survey of his lieraure. 2 Mulinaional aciviies are found o have relevan implicaions for a number of moneary policy issues, as, for insance, he choice of he mos appropriae exchange rae regime (Devereux and Engel (2)), he gains from inernaional moneary coordinaion (Cavallari (24)), he relaion beween exchange rae volailiy and FDI (Russ, 24) and he moneary ransmission worldwide (Cavallari (25)). 3 A non-exhausive lis of conribuions ha analyse he macroeconomic implicaions of rm enry and exi decisions includes Bilbiie, Ghironi and Méliz (25), Bergin and Corsei (25), Ghironi and Méliz (25), Corsei, Peseni and Marin (25) and Bergin and Glick (23a, 23b)). 3

4 while foreign direc invesmens enail only a xed cos for he seup of an a liae overseas. Fixed coss are sunk in he usual sense ha hey mus be paid prior o producion. Our model ress on he basic premise ha raded goods and goods produced by mulinaionals are imperfec subsiues. The assumpion capures he fac ha producing in he sales marke helps ailor a rm s produc o he ases of local consumers. In so doing, we depar from he reamen of mulinaional aciviies ha is convenionally aken in he lieraure, where he exisence of mulinaional enerprises is ypically relaed o he presence of economies of scale and love for variey. Our goal here is o show how we can improve our undersanding of he inernaional business cycle by simply appealing o cross-counry di erences in he mode of serving foreign markes. Remarkably, we nd ha rms inegraion sraegies play a key role in propagaing produciviy and moneary policy shocks. Moreover, accouning for mulinaional sales along wih rade allows o shed ligh on a number of puzzling feaures in erms of rade and exchange rae daa. We rs analyse he equilibrium where prices are exible and show ha cross-counry di erences in produciviy may lead o rising, falling or unchanged prices in inernaional markes depending on he mode of foreign marke access ha prevails in he world economy. In counries ha mosly rade beween each-ohers, he coss and bene s of a change in domesic produciviy are parially shifed ouside he domesic borders hrough he movemens in he erms of rade. A rise in home produciviy, by reducing he price of home expors, swiches world expendiure owards home goods, favouring home and foreign consumers as well. As long as counries engage in large bilaeral mulinaional aciviies, insead, he boos in domesic produciviy reduces he price ha home consumers face for foreign goods ye 4

5 leaving foreign-currency prices una eced. The price of domesic goods in inernaional markes e ecively rises. We nally sress ha relaive goods prices are almos invarian o counry-speci c produciviy levels in counries characerised by asymmeric inegraion sraegies, as developing and indusrialised economies. This in urn implies ha despie lower produciviy, less developed economies need no experience a secular deerioraion in heir erms of rade vis à vis indusrialised counries, as documened in long-horizon erms of rade daa for he wo groups of counries. In addiion, we nd ha movemens in inernaional goods prices may give rise o persisen deviaions from he purchasing power pariy, as apparen in real exchange rae daa for mos developing and indusrialised economies. The failure of he pariy is he resul of segmenaion in inernaional goods markes arising from cosly rade and mulinaional aciviies. In our seup wih endogenous enry, cross-counry di erences in produciviy may exacerbae marke segmenaion and lead o asymmeric inegraion sraegies in he world economy. A rise in domesic produciviy, for insance, by aracing new expor rms and mulinaionals in he home counry will reduce he price for domesic goods, wih he consequence ha he real exchange rae in home currency appreciaes whenever he weigh of raded goods in world consumpion is high and depreciaes oherwise. We hen consider he equilibrium wih pre-se prices and evaluae moneary policies in he class of linear rules. As long as prices are xed, a change in he global moneary sance a ecs world consumpion and oupu by changing he erms of rade and re-direcing spending across counries. In our seup wih rms enry, he e ecs of moneary policy on oupu are magni ed by he change in he invesmen demand for new rms. An easing of he global moneary sance has he poenial o arac or discourage new 5

6 invesors, depending on which one beween wo opposing e ecs prevails. On he one side, a moneary expansion, wherever i is originaed, is associaed wih lower discoun raes, hereby increasing he presen value of fuure profis for boh naional and mulinaional rms. On he oher side, however, a domesic moneary expansion migh discourage enry in he home counry insofar as i is associaed wih lower mark-ups in home expors and foreign mulinaional sales. We show ha a policy of complee sabilisaion can replicae he allocaion ha would prevail in an equilibrium where prices are exible, exending o a framework wih endogenous inegraion sraegies he resuls in Corsei and Peseni (22). Our analysis, however, highlighs ha a policy rade-o may maerialise when sabilisaion is no complee beween he need o reduce ucuaions in producers prices and he desire o allow for adjusmens in consumers prices. A policy of incomplee sabilisaion, by reducing he volailiy of marginal coss and herefore of pro s, induces rms o demand a lower premium in pre-deermined prices. The expecaion of lower producers prices, on he oher hand, migh discourage enry of new rms, hereby reducing he varieies ha will be available for consumpion. The opposed rade-o arises when a pro-cyclical moneary policy is in place. A moneary expansion when cyclical condiions urn favourable migh be jusi ed on he ground ha i helps reduce consumers prices by fosering compeiion among he producers of di eren varieies. The adjusmen in consumers prices, however, may come a he cos of higher and more variable producers prices. The paper is srucured as follows. Secion 2 models he world economy. Secion 3 derives he equilibrium allocaion when prices are exible and discusses he long-run implicaions of he model. Secion 4 examines he equilibrium in he world economy when prices are sicky and analyses he 6

7 e ecs of di eren degrees of moneary sabilisaion. Secion 5 concludes. 2 The model The world economy comprises wo counries, home and foreign, each populaed by a coninuum of agens of uni mass. Each agen in he world economy owns and operaes a rm which produces a unique variey of a di ereniaed raded good. Producion requires labour as he sole inpu. We consider expors and horizonal foreign direc invesmens as alernaive modes of serving foreign markes. Expors enail boh a variable iceberg-ype ranspor coss and a xed cos of paricipaing in he expor marke. A rm ha decides o inves in a producion faciliy locaed abroad, becoming a mulinaional enerprise, incurs only in he sunk enry cos. 2. Consumers Expeced lifeime uiliy of a ypical home agen i is given by: i = E X = U i (C i ; M i P ; Li ) () where ow uiliy U is a posiive funcion of real consumpion, C, and real money balances, M=P; a negaive funcion of labour e or, L; and is he discoun facor. In order o keep algebraic complexiy a a bare minimum, we adop he addiively-separable speci caion: wih > and >. U i = ln C i + ln M i P L i (2) Foreign agens preferences are expressed in an analogous way, bu are de ned over consumpion of goods sold in he foreign 7

8 counry, C ; foreign money balances, M =P, and foreign labour, L. 4 Each agen in he world economy consumes a baske ha comprises a non raded resource good, X, whose price, P X, is normalised o one, and a di ereniaed raded good, Z, as follows: C = X Z ( ) (3) C = X Z ( ) wih 2 (; ): Traded goods can be eiher expored or hey can be produced in he sales marke by local subsidiaries of mulinaional rms. We assume ha goods produced in di eren locaions are perceived as imperfec subsiues by nal consumers, wih elasiciy of subsiuion equal o one: where Z = Z = Z N Z M ( ) (4) Z N Z M ( ) 2 (; ): In our noaion, he subscrip indicaes wheher he good is expored by a naional rm, N, or produced in he sales marke by a mulinaional rm, M, so for insance, Z N represens foreign consumpion of impored goods. The consumpion index (4) capures a peculiar ype of love for variey, where goods varieies depends on where producion is locaed 5. The idea is ha consumers realize ha foreign goods can be beer ailored o 4 For fuure reference, foreign variables are denoed by aserisks. Unless oherwise saed, foreign prices and quaniies coincide wih he corresponding domesic variables and will no be explicily indicaed. 5 In our speci caion, consumers derive he same uiliy from consuming addiional unis of a given baske of foreign goods and spreading consumpion over a baske ha includes more varieies. This in urn implies ha supplying more varieies raises welfare whenever 8

9 heir ases once hey are produced in heir own counry. Local subsidiaries of mulinaional rms can, in fac, cusomize heir producs across locaions, for insance by incorporaing non-radable inpus or passing hrough local disribuion services. Traded goods appear in a nie mass of imperfecly subsiuable varieies indexed by! 2 (; m + n) for home goods and by! 2 (; m + n ) for foreign goods, where m is he number of home mulinaional rms and n he number of home expor rms and a similar inerpreaion holds for m and n. The number of rms acive in he world economy in each period will be deermined endogenously in he model. All varieies exhibi a consan elasiciy of subsiuion > : Z N = Z M = Z n Z m Z N (! ) ( ) d! Z M (! ) ( ) d! (5) Z N = Z M = Z n Z m ZN(!) ( ) d! ZM(!) ( ) d! In such an environmen rade is enirely inra-indusry in varieies of Z. 2.2 Firms All rms in he world economy have access o a linear echnology where labour is he only inpu. A rm locaed on he home soil faces he following producion funcion: he addiional varieies are e ecively consumed. See he discussion in Bilbiie, Ghironi and Méliz (25). 9

10 Y Z (!) = L Z (!) (6) Y Z (! ) = L Z (! ) where Y Z (!) is domesic oupu of he home variey!; Y Z (! ) is domesic oupu of he foreign variey! and is a sochasic erm capuring labour produciviy. Similar expressions hold in he foreign counry: YZ (! ) = L Z(! ) (7) YZ (!) = L Z(!) 2.2. Firms enry Enry ino he raded secor is free, bu o produce a variey of Z a rm mus bear a xed cos, becoming he sole producer of a unique variey. In order o sar producion a ime +, each enran pays a sunk ( xed) cos of q e ecive labour unis a home and q in he foreign counry 6. These coss capure a variey of xed coss which are associaed wih boh exporing and invesing overseas. Examples of xed coss of paricipaing in he expor marke include expor licences and oher adminisraive fees as well as oulays involved in obaining informaion abou he foreign marke. Fixed coss relaed o foreign invesmens include propery axes for subsidiaries abroad and he coss for he seup of local markeing and disribuion neworks. In each period, home expor rms and foreign mulinaionals need o employ = unis of home labour in order o sar producion in he subsequen period, hus facing he following enry coss: 6 Wihou loss of generaliy, we assume ha a home exporer and a foreign mulinaional enerprise will face he same enry cos on he home soil.

11 q = W Similarly, he enry cos faced by rms ha produce in he foreign counry is: q = W As i is common in proximiy-concenraion models, expors enail icebergype ranspor coss, so ha for one uni of he nal good o arrive a a foreign desinaion > unis mus be sen. These shipping coss capure a variey of (variable) coss associaed wih inernaional rade while no associaed wih foreign direc invesmens. 7 In each period, here is a nie mass of acive rms a home and in he foreign counry, m + n and m + n, respecively, as well as an unbounded mass of prospecive enrans, m E +n E and m E +n E. Enrans are forwardlooking and will access a marke insofar as heir fuure expeced pro s will cover enry coss. A he end of he period, afer producion has aken place, all rms exi he marke and a new producion process is iniiaed in every period. The number of acive rms in each period is herefore pre-deermined as follows: m = m E n = n E m = m E n = n E 7 Tari barriers range on average beween 4 and 5 per cen of he price of raded goods. Trade coss - including ari and non-ari barriers, shipping and disribuion coss - vary grealy across ypes of goods.

12 2.3 Individual and governmen s budge consrains In each period, he represenaive agen holds home currency, wo inernaional bonds, B i H and Bi F, respecively denominaed in home and foreign currency, and shares in domesic expor rms, s N, and mulinaional enerprises, s M. He receives labour income a he wage rae W for services provided o all rms acive on he home soil, a share in he pro s of home naional and mulinaional rms, N and M, respecively, and pays nondisorionary ne axes, T, o he governmen. The budge consrain of agen i is herefore: Z n E BH++" i BF i ++M++ i s N Z m E (!) q d!+ s M (!) " q d! B i H(+i + )+ (8) " B i F (+i +)+M i +W Z n L i h + L i f + s N Z m i Nd!+ s M i Md! P i C i T i where i and i are, respecively, home and foreign nominal ineres raes and " is he nominal exchange rae de ned as unis of home currency for one uni of foreign currency. The governmen simply rebaes all seigniorage revenue in lump-sum ransfers o households, so ha is budge consrain is as follows: Z M i M i di + Z T i di = (9) 2.4 The equilibrium allocaion 2.4. Firs order condiions Home agens maximize uiliy (2) wih respec o C, X, Z N (! ); Z M (! ); L, M, s N (!), s M (!), B and B subjec o heir budge consrain (8). The 2

13 rs order condiions are: C = P () X, = P X Z N (! ) = ( ) ( ) P N pn (! ) () P N Z M (! ) = ( ) P M pm (! ) (2) P M W = (3) M = + i + i + (4) q = E + N +(!) (5) " q = E + M +(!) (6) = E ( + ( + i + )) (7) " = E + " + + i + (8) where he Lagrange muliplier measures he marginal uiliy of home currency and he uiliy-based price indices are de ned as follows: P = P X P Z (9) P Z = P ZM P ZN (2) 3

14 P ZM = P ZN = Z m Z n p ZM (! ) d! p ZN (! ) d! (2) Following Corsei and Peseni (25), i is useful o de ne an index of he moneary sance such ha a moneary expansion, i. e. a rise in ; is associaed wih a lower ineres rae: P C = (22) Free enry condiions Using (22), (3) and (2) as well as heir foreign analogues, we can wrie he free enry condiions for foreign and home mulinaional rms as follows: = E p Z M (! ) m ( ) + + P Z M (23) = E p ZM (!) + + (m + ) + ( ) + PZM The above expressions say ha mulinaional enerprises will inves in a foreign faciliy abroad as long as he expeced presen value of operaive pro s in he subsequen period, on he righ hand side, will cover enry coss. The free enry condiions for expor rms are similarly given by: = E p ZM (!) + (n + ) ( ) ( ) P ZM (24) 4

15 " = E p Z N (! ) n ( ) ( ) + + " + PZ N Opimal Prices Monopolisic compeiors se prices so as o maximize he expeced presen value of pro s given marke demand () and (2). In he absence of nominal rigidiies, opimal prices are se a a consan mark up on nominal marginal coss: ep ZN (!) = " ep Z M (! ) = ep ZM (!) = ep Z N (! ) = " (25) where =( ) is an index of monopoly disorions in he world economy, = and = are nominal marginal coss, respecively, a home and abroad and a ilde over a variable indicaes ha i is calculaed wih exible prices. Our model allows for nominal rigidiies by assuming ha rms se he price of heir produc a he beginning of each period, before shocks and enry realize, and are commied o mee marke demand a he given price for one period. We assume ha goods produced in he sales markes are priced in local currency, despie subsidiaries of mulinaional rms could in principle se prices in heir own currency and le he local currency price of heir producs vary wih he nominal exchange rae. The assumpion is consisen wih an ample evidence showing ha mulinaional rms do engage in subsanial pricing o marke aciviies hrough heir sales faciliies overseas (Lipsey, 5

16 999). Opimal pre-deermined prices for goods produced in he sales markes are se as follows: p ZM (!) = E ( ( )2 ) E ( ) p Z M (! ) = E ( ( ) 2 ) E ( ) (26) where a bar over a variable indicaes ha i is derived wih xed prices. I is worh noicing ha prese prices incorporae a risk premium over expeced marginal coss which arises from he covariance of pro s wih he marginal uiliy of consumpion. A di eren assumpion is made for raded goods, whose price can be se in he currency of consumers, in he one of producers or according o any combinaion of hese wo pricing sraegies. Empirical evidence on raded good prices, as documened by, among ohers, Goldberg and Kneer (997), Engel (999), Parsley and Wei (2) and, more recenly, Campa and Goldberg (24) poins o a degree of exchange rae pass-hrough ino impor prices which is higher han zero on average alhough far below uniy. Following Corsei and Peseni (25), we assume ha rms se he foreign-currency price for heir producs according o he following scheme: p ZN(!) = bp N (!)" p Z N (! ) = bp N (! )" (27) where bp N (!) is he pre-deermined price for variey! of he home raded good in home currency and bp N (! ) is he pre-deermined foreign-currency price for variey! of he foreign raded good. In his seing, = = corresponds o local currency pricing: rms se prices in he consumers 6

17 currency, so ha prices consumers face do no respond o movemens in he exchange rae. The case = = corresponds o producers currency pricing: producers se he price in heir own currency, implying ha impor prices move in he same proporion as he nominal exchange rae. Opimal price seing for raded goods yields: p ZN (!) = E ( "+ ) " E ( " ) p Z N (! ) = E ( " " E ( " ) ) (28) Opimal prices (28) and (26) are valid for any disribuion of he underlying shocks, provided he paricipaion consrains are no violaed: bp N (!) p ZM (!) p Z M (! ) bp N (! ) (29) In wha follows, he domain of he shocks is resriced so ha he above consrains are always sais ed Resource consrains Asse markes equilibrium implies ha inernaional bonds are in zero ne supply: Z B i Hdi + Z B i Hdi = Z B i F di + Z B i F di = (3) Marke clearing on goods markes requires ha he world supply coincides wih world demand: 7

18 Z m Z n Y Z (!) d! Z M Z m Z n Y Z (! ) d! Z M (3) Y Z (!) d! Z N X Z X i di X Y Z (! ) d! Z N Z X i di Finally, equilibrium in labour markes yields: L (Y ZN + Y Z M ) (32) L (Y ZM + Y Z N ) where L R Li di and L R Li di are home and foreign labour force, respecively, and he erms in brackes represen home and foreign GDP: Soluion sraegy The model is solved in a symmeric equilibrium where rms se idenical prices for he di eren varieies, implying he following price indices: PZN = (n ) p ZN P Z M = (m ) PZM = (m ) p ZM P Z N = (n ) pz M pz N We assume iniial nancial auarky in each counry, i. e. B H = BF = ; so ha ne asses will be equal o zero in any poin in ime, as usual in his class of models. 8 8 As poined by Corsei and Peseni (22), a balanced curren accoun is he resul of hree hypohesis: i) a Cobb-Douglas consumpion index ii) logarihmic uiliy in consumpion and iii) zero iniial ne asses. 8

19 Aggregaing he budge consrains (8) across home agens and using he governmen (9) and resource consrains (3) and (32), yields he aggregae accouning ideniy for he home economy: P C + m E " q + n E q = W L + m M + n N + P X X (33) where consumpion plus invesmen in new rms, on he lef-hand side, mus be equal o oal income, i. e. labour income plus dividend income and he endowmen of he non raded resource. Re-arranging he above expression, we can wrie he balance of paymens in erms of home currency as follows: " P ZNZ N P Z N Z N + W Z M " W Z M + m E q m E " q = (34) The rs wo erms consiue he rade balance, i. e. home expors less home impors. The hird erm is labour income ha home agens receive from foreign mulinaionals and he fourh erm is labour income ha home mulinaionals pay in heir a liaes abroad, heir di erence is herefore ne facor paymens. The sum of he rade balance and ne facor paymens consiues he curren accoun. The las wo erms are he nancing of foreign direc invesmens owards and from he home economy and heir di erence is he capial accoun of he balance of paymens. The balance of paymens equilibrium (34) ogeher wih he free enry condiions (23) and (24) allow o joinly deermine he endogenous " ; m E, m E ; n E and n E. The remaining variables are easily obained using opimal pricing (25) for he exible price equilibrium, (26) and (28) in he equilibrium wih nominal rigidiies, and deriving C and L from, respecively, () and (3). 9

20 3 The exible price benchmark In his secion we characerise he equilibrium when prices are exible. Firs, we wrie he operaive pro s of a ypical mulinaional rm as a share of global sales: M (! ) = M (!) = ( ) m ( ) " m The above expressions highligh ha he pro s of a mulinaional enerprise are negaively associaed wih he oal number of mulinaionals acive in he marke. Inuiively, his is a consequence of increased compeiion among he producers of similar varieies, which induces each rm o ry and expand is marke share by reducing he price for is own variey. In a symmeric equilibrium where all prices are cu by he same amoun, rms revenues and herefore pro s will hen decline. A he macroeconomic level, aggregae pro s are independen on he number of rms as he drop in consumers prices is mached by a corresponding rise in aggregae spending (recall ha he elasiciy of demand is one in our model). Similarly, he pro s of expor rms are a consan share of he oal revenues from selling heir producs. We hen we use he above equaions and heir analogues for expor rms in (23), (24) and (34), yielding: em E = ( ) (35) em E = ( ) 2

21 en E = ( ) ( ) (36) en E = ( ) ( ) e" = (37) Comparing (35) and (36), i appears ha he choice wheher o access foreign markes hrough expors or mulinaional sales crucially depends on he balance beween rade and enry coss a home and abroad: he share of home rms ha decide o inves in a subsidiary locaed abroad is posiively associaed wih rade coss and relaive produciviy =. Moreover, he capaciy of a mulinaional enerprise o save on rade coss and ake advanage of cross-counry di erences in produciviy is magni ed whenever agens prefer o consume goods produced in heir own marke, i.e. when is high. The number of enrans each period is posiively associaed wih curren produciviy levels: a rise in home produciviy will arac foreign mulinaionals and home expor rms by reducing he coss of esablishing a new producion faciliy on he home soil. I is noeworhy o sress ha variables which in principle could a ec pro s in he subsequen period do no play any role in rms enry whenever prices are exible. Despie he expecaion of, say, a rise in marginal coss in he fuure, naional and mulinaional enerprises will no reduce heir invesmens as hey will be able o mainain a consan mark-up by charging higher prices ono consumers. A ucuaion in marginal coss will raher a ec he inensive margins. We can easily show ha he level of employmen is consan in equilibrium, 2

22 as given by: el = ( ( ) n + m el = ( ( ) n + m + ( + ( )) A (38) + ( + ( )) A implying ha a rise in home produciviy, an increase in, will jus lead o an increase in oupu per rm. Variable inensive margins along he cycle are a consequence of smoohing labour e or across ime. A change in world oupu mus be mached by a corresponding change in world consumpion. As will be apparen soon, he way ucuaions in world consumpion spread among home and foreign consumers depends crucially on inernaional inegraion sraegies. Consider he equilibrium levels of consumpion a home and abroad as given by: ec = a () ( ) ( ) ( )( ) (39) ec = a ( ) ( ) ( )( ) () where consans are de ned as follows: a () ( )( ) n a () ( )( ) n m m ( ) ( ) Consumpion is high whenever monopoly disorions are low and he number of acive rms is large in he world economy. A rise in domesic produciviy raises consumpion boh a home and abroad, wih subsanial inernaional spillovers among open economies. 9 9 In our model, rade openness is capured by he parameers ( ) ( ). 22

23 In counries wih srong bilaeral rade ies, namely when! ; movemens in he erms of rade ensure ha he bene s and coss from counryspeci c produciviy shocks disseminae around he world, changing he composiion of world spending. The rise in home produciviy, in fac, by reducing he price of goods produced in he home counry will deeriorae he home erms of rade - " e P ZN = e P Z N decrease - hereby shifing world spending owards home goods. As a consequence, consumpion will increase a home as well as abroad. Home produciviy shocks, on he conrary, do no spill-over ono foreign consumers whenever rms mainly operae hrough subsidiaries abroad,!. The only consequence of he produciviy rise a home will be a lower price for he producs of foreign mulinaionals, implying ha he relaive price " e P ZM = e P Z M in inernaional markes will raher increase. Goods markes become e ecively insulaed when counries engage in large bilaeral mulinaional aciviies. 3. Firms inegraion sraegies and macroeconomic inerdependence 3.. Rich versus poor counries Our model has ineresing implicaions for counries ha are characerised by asymmeric inegraion sraegies, as indusrialised and developing economies. Suppose ha enry coss are close o zero a home (he developing economy) and prohibiively high abroad (he indusrialised counry), so ha mos rms decide o locae producion in he home counry. In such a siuaion, I is immediae o realise from (35) and (36) ha boh n and m are close o zero whenever = ends o in niy, implying ha home rms will serve foreign markes 23

24 counry-speci c shocks o produciviy, wherever hey are originaed, do no a ec he relaive price " e P ZN = e P Z M for di eren ypes of raded goods. ha home and foreign consumers face Consequenly, world expendiure will hardly reac o inernaional produciviy di erenials. The nding is consisen wih he evidence showing ha, despie lower rend produciviy, less developed counries need no experience a secular deerioraion in heir erms of rade relaive o he developed world. Moreover, a drop in ransporaion coss, by reducing he price of raded goods, will deeriorae he erms of rade in counries, like he home economy in our example, ha mainly serve foreign markes hrough expors. This implies ha a policy of rade liberalisaion, as represened by a symmeric, worldwide decrease in iceberg-ype ranspor coss, reduces he purchasing power of consumers in less developed economies, who need o supply more labour e or in order o buy a given uni of he foreign good. This is no o say, however, ha rade liberalisaion is necessarily couner-producive for developing economies. The negaive wealh e ec of rade liberalisaion, in fac, migh be more han compensaed in welfare erms by he boos in he exernal demand for heir producs The failure of he PPP In our model, he purchasing power pariy may no hold, despie exible prices. Many sudies documen ha real exchange rae movemens are highly hrough expors, while foreign rms will engage in mulinaional aciviies. The long-lasing debae on he secular deerioraion of he erms of rade of developing counries was iniiaed by Singer (95). I is currenly widely acceped ha he erms of rade across developed and less developed counries move o a much lesser exen han previously hough and may no have a secular rend, once ranspor coss, produc qualiy and cross-counry specialisaion paerns are accouned for (Salvaore, 2). 24

25 persisen, so much ha he hypohesis of uni roos in real exchange rae daa can hardly be rejeced for mos indusrialised and developing counries. 2 Deviaions from PPP inroduce a furher disorion in he economy on op of ha arising from monopolisic compeiion. As long as a change in he nominal exchange rae leads o small movemens in consumer prices, moving he real exchange rae, in fac, here will be an ine cien change in he price of very similar bundles of goods. Consider he real exchange rae R "P =P; as de ned using he consumpionbased price indices in he wo economies: er = n n m m ( )( 2 ) (4) As apparen from he above equaion, deviaions from he purchasing power pariy, i.e. movemens in R; may arise as a resul of changes in he varieies of goods available for consumpion in he world economy. A rise in he number of varieies exchanged wih he res of he world is associaed wih an appreciaion of he real exchange rae in home currency, i. e. a fall in R. Tougher compeiion among home exporers and mulinaional enerprises will in fac reduce he foreign-currency price of home goods. The pariy may also fail due o cross-counry di erences in produciviy levels, as well known since Balassa (964) and Samuelson (964). The Balassa-Samuelson e ec says ha counries wih higher produciviy in radables wih respec o non radables end o have higher price levels and herefore heir exchange rae appreciaes in real erms. In equaion (4), a rise in 2 Early saionariy ess for real exchange rae daa are surveyed in Rogo (996). See Froo and Rogo (996) for a very long-run perspecive on PPP. The convergence o pariy remains very slow even when srucural changes in long-horizon ime series are accouned for: i akes more han 5 years on average for he exchange rae o reurn o is long-run mean or rend (Murray and Papell (22), Lohian and Taylor (996)). 25

26 home produciviy is associaed wih a real appreciaion in home currency as long as he weigh of raded goods in world consumpion is large enough, namely whenever < =2: This is consisen wih he evidence showing ha movemens in real exchange raes are mainly driven by changes in he erms of rade. 3 Furhermore, in our seup wih endogenous enry, crosscounry di erences in produciviy may exacerbae deviaions from he pariy by leading o asymmeric inegraion sraegies worldwide. Insofar as a rise in home produciviy aracs new enrans in he home counry, in fac, home rms will mainly serve foreign markes hrough expors while foreign rms will mainly operae hrough local branches of mulinaional enerprises. Consequenly, he rise in produciviy may appreciae or depreciae he real exchange rae in home currency depending on he weigh of raded goods in world consumpion. 4 The shor-run equilibrium In his secion we characerise he equilibrium when monopolisic compeiors se prices in advance of shocks and before enry akes place. The soluion sraegy follows he same seps as before excep for he fac ha opimal pre-se prices (26) and (28) will replace heir exible price counerpars. 4. Firms enry and exchange raes The number of enrans and he exchange rae in economies wih sicky prices are given by: 3 Engel (999) documens ha he relaive price of non radable goods hardly maers for real exchange raes. Flucuaions in he nominal exchange rae, on he oher side, appear o be highly correlaed wih erms of rade movemens. 26

27 n E = n E = m E = m E = ( ) ( ) ( ) ( ) ( ) ( ) " = " @ " E ( + + ) P Z M + E ( + + ) P ZM+ E ( + + ) P Z N + E ( + + ) P ZN+ 2 me ( ) ( ) 4 ( ) ( ) m E 3 # (4) A5 (42)!# 5 (43) Firs, observe ha he number of enrans in equaions (4) and (42) may di er from he one ha prevails wih exible prices. Enry behaviour is idenical in he wo pricing regimes only when pre-deermined prices are se as a mark-up on expeced marginal coss 4 As already noed, his will no generally be he case and prices will raher incorporae a premium (or a discoun) as a hedge agains he risk of a decline in pro s. 5 Firms pro s, in fac, depend on he fuure realisaions of marginal coss, = a home and = in he foreign counry, as well as on he covariance beween 4 Noe ha he erm in square brackes blurs o = when prices mark-up nominal marginal coss. 5 The pre-deermined price for, say, foreign mulinaional sales, can be wrien as follows: P Z M = " E ( ) + cov( # ; ) E ( ) where he second erm in brackes is he risk premium. Similar expressions hold for he oher pre-se prices. 27

28 hese variables and nominal spending, respecively, and. Whenever a rise in home produciviy is associaed wih an increase in, as under a couner-cyclical moneary rule, nominal marginal coss are a leas parially sabilised and rms can consequenly demand a lower premium. By he same oken, a higher risk-premium will be demanded when marginal coss are negaively associaed wih nominal spending. This in urn implies ha he disance beween m E and n E on he one side and em E and en E on he oher side is increasing wih he covariance beween nominal spending and nominal marginal coss. As will be apparen in he following secion, his has relevan implicaions for moneary policy. Addiionally, we sress ha di erenly from he enry behaviour under exible prices, a rise in expeced marginal coss migh a ec enry as long as i is no mached by a corresponding rise in pre-se prices. 6 As a consequence, an insu cien or excessive number of varieies migh be produced in he equilibrium wih nominal rigidiies. The possibiliy ha expecaions a ec enry of mulinaional enerprises and herefore foreign direc invesmens has imporan implicaions for he nominal exchange rae, as evidenced by he presence of m E and m E in equaion (43). In order o see he poin, suppose o sar from an equilibrium characerised by balanced curren and capial accouns and hen expecaions of a deerioraion in home marginal coss maerialise. Wih exible prices, his would have no implicaions for rms enry, as prospecive enrans know 6 Taking he derivaive of m E wih respec o E( ) and re-arranging he resuling expression, we E ) = sign cov( ; ) E() + E( ) 2! A rise in marginal coss is associaed wih a fall in he number of enrans whenever he covariance erm is posiive. 28

29 ha hey will be able o raise prices in he following period should he rise in marginal coss e ecively occur. The sory is di eren when prices are se in advance of shocks: enry in he home marke migh be discouraged and foreign direc invesmens will ow away from he home counry, m E decrease. This in urn implies ha he home currency needs o depreciae so as o mainain he balance of paymens equilibrium. will The nding ha shor-run ucuaions of exchange raes may be driven by non-fundamenal forces is a well-known fac in inernaional macroeconomics. 4.2 Inernaional spillovers The levels of consumpion and employmen in he equilibrium wih predeermined prices are given by: ( )( ) C = a 2 " (44) C = a 2 " ( )( ) L = L = ( ) ( ) " + bp ZN ( ) ( ) " bp Z N + P ZM P Z M!! + me + me + n E + n E (45) where he consans are de ned as follows: ( ) ( ) a 2 P Z M bp Z N a 2 P ( ) ( ) bpzn ZM As long as prices are sicky, consumpion, employmen and oupu in he world economy are posiively associaed wih global moneary condiions. Moneary policy is ransmied in he world economy hrough changes in 29

30 world demand and he erms of rade. Equaions (44) and (45) highligh ha moneary ransmission crucially depends on rms inegraion sraegies worldwide, as capured by he parameer. The capaciy of moneary auhoriies o a ec inernaional prices and re-direc expendiure across counries is magni ed in a high pass-hrough environmen, i.e. when = ' and he share of mulinaional enerprises is small,!. A moneary expansion a home, by depreciaing he home currency, will deeriorae he home erms of rade, hereby swiching world expendiure in favour of less expensive home goods. Consumpion will consequenly rise in boh counries. Worldwide employmen needs o increase as well so as o provide a larger amoun of goods for consumpion. 7 An easing of he home moneary sance, insead, will have no consequences for he foreign economy when prices are invarian o exchange rae movemens, as i is he case when prices are mainly se in he consumers currency and foreign markes are mainly served by mulinaional enerprises. Finally, we sress ha produciviy shocks have a minor role in he equilibrium wih pre-se prices, where boh he inensive and exensive margins are consan. A produciviy rise in he home counry leads o a corresponding reducion in he level of employmen according o (45), leaving oupu per rm unchanged. The nding is consisen wih he so-called New Keynesian view of he business cycle, as synhesised by Clarida, Galì and Gerler (999), showing ha aggregae consumpion and oupu are mainly driven by ucuaions in aggregae demand. 7 Evaluaing (45) wih = ; i appears ha a one percen increase in he home money supply leads o a percen rise in L and a percen rise in L : 3

31 4.3 Moneary sabilisaion Moneary policy, by conrolling nominal spending, can help reduce he disorions due o nominal rigidiy and even replicae he equilibrium allocaion ha would prevail wih exible prices. In order o see he poin, we consider he mos favourable scenario for moneary policy where exchange rae pass-hrough is complee and evaluae he class of simple linear rules: where 2 ( = (46) = ; ) measures he degree of moneary inervenion in he economy. A posiive implies a couner-cyclical policy, namely a siuaion where a rise in marginal coss is associaed wih a moneary expansion. The moneary rule is pro-cyclical when is negaive. We rs esablish ha a policy of full sabilisaion, namely a rule such ha = ; can resore he exible price allocaion, as apparen afer subsiuing he above rule ino (4), (42), (44) and (45). The nding generalises o a framework where rms can choose beween di eren modes of foreign marke access a similar resul in Corsei and Peseni (22). 8 When a policy of complee sabilisaion is in place, moneary auhoriies move nominal spending so as o o se any change in domesic produciviy and bridge he oupu gap. This in urn implies ha nominal marginal coss will be sabilised in he world economy and rms will have no incenive o change prices even if hey were allowed o do so. In a fully sabilised economy, producers prices are consan while consumers prices may vary wih he number of rms ha ener home and foreign markes. A fall in world enry coss, as 8 Bergin and Corsei (25) also nd ha linear moneary rules can replicae he exible price equilibrium in a closed-economy model wih rms enry. 3

32 a drop in, by aracing expor rms and mulinaional enerprises, will reduce (wih one period lag) he price ha consumers will face for raded goods and mulinaional sales. Second, we consider a Friedman-ype rule such ha money supply follows a deerminisic pah independen of curren cyclical condiions, as capured by = in (46). Inspecion of equaions (4) and (42) reveals ha he enry behaviour under such a rule is he same as in he equilibrium wih exible prices. Inuiively, his is due o he fac ha nominal marginal coss and herefore pro s are no correlaed wih nominal spending when a deerminisic moneary rule is in place, implying ha prices simply mark-up expeced nominal marginal coss. Expeced pro s will hen be he same independenly of wheher rms will be able o change heir prices in he subsequen period. Despie he number of varieies available for consumpion is he same as when prices are exible, producers prices will be higher han in a sabilised economy and he more so he more volaile produciviy levels. 9 This in urn implies ha consumpion and employmen will be sub-opimally low when produciviy is high and he opposie is rue in case of a decline in produciviy. In he inermediae case where moneary policy parially sabilises he economy, i.e. when < <, we sress ha a policy rade-o may maerialise beween he need o reduce ucuaions in producers prices on he one hand and he desire o faciliae adjusmens in consumers prices on he oher hand. Compared o he lack of sabilisaion, a policy of incomplee sabilisaion has he advanage of reducing boh he level and volailiy of producers prices. Firms, in fac, realise ha he risk of a decline in pro s is 9 When he simple rule is in place, he price for goods produced a home is E( ): Wih iid shocks, his price is increasing wih he variance of. 32

33 lower when a couner-cyclical policy is in place and will consequenly demand a lower premium (or a higher discoun) on pre-se prices. On he oher side, however, he fall in producers prices migh discourage enry, as evidenced in equaions (4) and (42), hereby reducing he varieies of goods ha will be available for consumpion in he following period. An opposie conclusion can be drawn for a pro-cyclical policy, <. Easing moneary policy when cyclical condiions urn favourable migh be jusi ed by he desire o arac new rms so as o mimic he consumpion bundle ha would prevail in an economy wih exible prices. Replicaing he exible-price invesmen dynamics, however, comes a he cos of higher and more variable producers prices. 5 Conclusions This conribuion has incorporaed mulinaional sales along wih rade in a general-equilibrium open economy macroeconomic model wih endogenous enry so as o invesigae he role of rms inegraion sraegies in propagaing business cycle ucuaions. The analysis has focused on produciviy and moneary policy shocks. In he benchmark model where prices are exible, we nd ha di erences in rms inegraion sraegies can help explain a number of puzzling feaures in long-horizon daa for key inernaional prices. Firs, we show ha a rise in domesic produciviy can be associaed wih a permanen rise or a fall in he relaive price for domesic goods in inernaional markes, consisenly wih he evidence showing ha correlaions beween relaive prices and oupu vary signi canly across counries (Backus and Crucini (2). In our seup, domesic goods prices are posiively associaed wih domesic 33

34 produciviy levels whenever counries engage in large bilaeral mulinaional aciviies. An increase in domesic produciviy leads o an increase in domesic oupu and a fall in he relaive price of domesic goods, hereby raising he relaive price for home mulinaional sales. Second, inernaional prices are found o be almos invarian o relaive produciviy in counries characerised by asymmeric inegraion sraegies, as indusrialised and developing economies. This in urn implies ha despie lower produciviy, less developed economies need no experience a secular deerioraion in heir erms of rade wih indusrialised economies, as documened in long-horizon erms of rade daa for he wo groups of counries. Finally, we sress ha in our model wih endogenous enry, cross-counry di erences in produciviy may exacerbae segmenaion in inernaional goods markes and lead o persisen deviaions from he purchasing power pariy. In he regime where prices are pre-se, we nd ha rms inegraion sraegies play a key role in propagaing moneary policy shocks. An easing of he home moneary sance is shown o boos consumpion and oupu mainly a home whenever consumers prices are invarian o a change in he nominal exchange rae, as when rms serve foreign markes hrough local a liaes and se prices in local currency. Moreover, in our seup wih endogenous enry, moneary policy can also a ec he invesmen demand for new rms, boh naional and mulinaional enerprises, hereby changing he varieies of goods ha will be available for world consumpion. We nd ha a policy of complee sabilisaion can replicae he allocaion ha prevails when prices are exible, exending o a framework wih rms enry an analogous resul in Corsei and Peseni (22). Our analysis, however, suggess ha he nding may no be robus. We show ha a policy rade-o may maerialise when sabilisaion is no complee beween he desire o smooh ucuaions 34

35 in producers prices on he one hand and he need o faciliae adjusmens in consumers prices on he oher hand. The advanage of lower and less variable producers prices, by discouraging enry of new rms, may come a he cos of lower varieies being consumed (a higher prices) in he world economy. References [] Anràs P. and E. Helpman, 24, Global Sourcing, Journal of Poliical Economy 2: [2] Aizenman J. and N. Marion, 24, The Meris of Horizonal versus Verical FDI in he Presence of Uncerainy, Journal of Inernaional Economics, 62: [3] Backus D.K. and M. J. Crucini, 2, Oil Prices and he Terms of Trade, Journal of Inernaional Economic, 5:85-23 [4] Backus D.K., P. Kehoe and F.E. Kydland, 992, Inernaional Real Business Cycles, Journal of Poliical Economy : [5] Balassa B., 964, The purchasing power pariy docrine: a reappraisal, Journal of Poliical Economy 72: [6] Bergin P. and R. Glick, 23a. A Model of Endogenous Non-radabiliy and is Implicaions for he Curren Accoun, mimeo, Universiy of California Davis and Federal Reserve Bank of San Francisco [7] Bergin P. and R. Glick, 23b. Endogenous Non-radabiliy and Macroeconomic Implicaions, NBER working paper

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