Beyond Competitive Devaluations: The Monetary Dimensions of Comparative Advantage

Transcription

1 Beyond Compeiive Devaluaions: The Moneary Dimensions of Comparaive Advanage Paul R. Bergin Deparmen of Economics, Universiy of California a Davis, and NBER Giancarlo Corsei Cambridge Universiy and CEPR This draf March 26 Absrac Moivaed by he long-sanding debae on he pros and cons of compeiive devaluaion, we propose a new perspecive on how moneary and exchange rae policies can conribue o a counry s inernaional compeiiveness. We refocus he analysis on he implicaions of moneary sabilizaion for a counry s comparaive advanage. We develop a wo-counry New-Keynesian model allowing for wo radable secors in each counry: while one secor is perfecly compeiive, firms in he oher secor produce differeniaed goods under monopolisic compeiion subjec o sunk enry coss and nominal rigidiies, hence heir performance is more sensiive o macroeconomic uncerainy. We show ha, by sabilizing markups, moneary policy can foser he compeiiveness of hese firms, encouraging invesmen and enry in he differeniaed goods secor, and ulimaely affecing he composiion of domesic oupu and expors. Keywords: moneary policy, producion locaion exernaliy, firm enry, opimal ariff JEL classificaion: F4 We hank our discussans Maeo Cacciaore, Fabio Ghironi, Paolo Peseni, and Hélène Rey, as well as Mary Amii, Giovanni Maggi, Sam Korum, Kim Ruhl, and seminar paricipans a he 23 NBER Summer Insiue, he 23 Inernaional Finance and Macro Finance Workshop a Sciences Po Paris, he 23 Norges Bank Conference The Role of Moneary Policy Revisied, he 24 ASSA meeings, he 24 Wes Coas Workshop on Inernaional Finance and Open Economy Macroeconomics, he CPBS 24 Pacific Basin Research Conference, he 24 Banque de France PSE Trade Elasiciies Workshop, Bank of England, Bank of Spain, London Business School, New York FED he Naional Universiy of Singapore, Universidade Nova de Lisboa, and he Universiies of Cambridge, Wisconsin, and Yale for commens. We hank Yuan Liu, Riccardo Trezzi and Jasmine Xiao for excellen research assisance. Giancarlo Corsei acknowledges he generous suppor of he Keynes Fellowship a Cambridge Universiy, he Cambridge Ine Insiue and Cenre for Macroeconomics. Paul R. Bergin, Deparmen of Economics, Universiy of California a Davis, One Shields Ave., Davis, CA Phone: (53) prbergin@ucdavis.edu. Giancarlo Corsei, Faculy of Economics, Cambridge Universiy Sidgwick Avenue Cambridge CB3 9DD Unied Kingdom. Phone: +44() gc422@cam.ac.uk.

2 . Inroducion This paper offers a new perspecive on how moneary and exchange rae policy can srenghen a counry s inernaional compeiiveness. Convenional policy models emphasize he compeiive gains from currency devaluaion, which lowers he relaive cos of producing in a counry over he ime span ha domesic wages and prices are sicky in local currency. In modern moneary heory and cenral bank pracice, however, reliance on devaluaion o boos compeiiveness is no viewed as a viable policy recommendaion on wo accouns. Firs, i may be inerpreed as a sraegic beggar-hy-neighbor measure, inviing realiaion up o causing currency wars, and second, i is bound o worsen he shor-run rade-offs beween inflaion and unemploymen. Conversely, recen conribuions o he New Open Economy Macro (NOEM) and New-Keynesian (NK) radiion sress ha moneary policymakers can exploi a counry s monopoly on is erms of rade. As his ypically means pursuing a higher inernaional price of home goods, he implied policy goal appears o be he opposie of improving compeiiveness. In his paper, we ake a differen perspecive, and explore he relevance for a counry s comparaive advanage of adoping moneary and exchange rae regimes which may or may no deliver efficien macroeconomic sabilizaion. We moivae our analysis wih he observaion ha moneary policy aimed a sabilizing marginal coss and demand condiions a an aggregae level (weakening or srenghening he exchange rae in response o cyclical disurbances) is likely o have asymmeric effecs across secors. Sabilizaion policy can be expeced o be more consequenial in indusries where firms face higher nominal rigidiies ogeher wih significan up-fron invesmen o ener he marke and price producs---feaures ypically associaed wih differeniaed manufacuring goods. To he exen ha moneary policy ensures domesic macroeconomic sabiliy, i creaes favorable condiions for firms enry In virually all conribuions o he new-open economy macroeconomics and New-Keynesian lieraure, he rade-off beween oupu gap and exchange rae sabilizaion is mainly modeled emphasizing a ermsof-rade exernaliy (see Obsfeld and Rogoff (2) and Corsei and Peseni (2, 25), Canzoneri e al. (25) in he NOEM lieraure, as well as Benigno and Benigno (23), and Corsei e al. (2) in he New-Keynesian lieraure, among ohers). Provided he demand for expors and impors is relaively elasic, an appreciaion of he erms of rade of manufacuring allows consumers o subsiue manufacuring impors for domesic manufacuring goods, wihou appreciable effecs in he marginal uiliy of consumpion, while reducing he disuiliy of labor. The opposie is rue if he rade elasiciy is low.

3 in such indusries, wih poenially long-lasing effecs on heir compeiiveness, and hus on he weigh of heir producion in domesic oupu and expors. To illusrae our new perspecive on he subjec, we specify a sochasic generalequilibrium moneary model of open economies wih incomplee specializaion across wo radable secors. In one secor, convenionally idenified wih manufacuring, firms produce an endogenous se of differeniaed varieies operaing under imperfec compeiion; in he oher secor, firms produce highly subsiuable, non-differeniaed goods---for simpliciy we assume perfec compeiion. The key disincion beween hese secors is ha differeniaed good producers face a combinaion of nominal rigidiies and sunk enry coss ha make hem more sensiive o macroeconomic uncerainy. The key resul from our model is ha efficien sabilizaion regimes affec he average relaive price of a counry s differeniaed goods in erms of is nondiffereniaed goods, and, relaive o he case of insufficien sabilizaion, confer comparaive advanage in he sale of differeniaed goods boh a home and abroad. Underlying his resul is a ransmission channel a he core of modern moneary lieraure: in he presence of nominal rigidiies, uncerainy implies he analog of a risk premium in a firm s opimal prices, depending on he covariance of demand and marginal coss (See Obsfeld and Rogoff 2, Corsei and Peseni 25 and more recenly Fernandez-Villaverde e al. 2). We show ha, by impinging on his covariance, and hus on he variabiliy of he ex-pos markups, opimal moneary policy conribues o manufacuring firms seing efficienly low, compeiive prices on average, wih a posiive demand exernaliy affecing he size of he marke. A large marke in urn srenghens he incenive for new manufacuring firms o ener, see e.g., Bergin and Corsei (28) and Bilbiie, Ghironi and Meliz (28). An implicaion of he heory ha is relevan for policy-relaed research is ha, everyhing else equal, counries wih a reduced abiliy o sabilize macro shocks will end o specialize away from differeniaed manufacuring goods, relaive o he counries ha use heir independen moneary policy o pursue inflaion and oupu gap sabilizaion. We calibrae our model, including TFP shocks based on novel esimaes of he TFP process for differeniaed and non-differeniaed secors in he US vis-à-vis an aggregae of European counries. In he calibraed model we find ha he uncondiional mean of he share of a counry s expors in differeniaed goods subsanially falls if a counry replaces 2

4 opimal moneary rules wih a unilaeral peg implying insufficien oupu gap sabilizaion. The size of he conracion, beween one and wo percen in mos calibraions, is consisen wih he presumpion ha moneary policy regimes may be expeced o have a moderae impac on real allocaion, bu we also show economies in which he conracion is as high as 9 percen. Our model is relaed o closed-economy lieraure analyzing sabilizaion in mulisecor economy (such as Bodensein, e al., 28), wih a key difference. Via marke dynamics, rade coss creae an exernaliy ha amplifies he implicaions of sabilizaion policies for firm enry and he secoral composiion of naional oupu. This exernaliy markedly differeniaes he presen paper from earlier work of ours, also analyzing he relevance of moneary policy for marke dynamics in a closed economy conex. From he perspecive of rade heory, our analysis is relaed o leading work on ariffs by Ossa (2), which noneheless absracs from nominal rigidiies and oher disorions ha moivae our focus on sabilizaion policy. Ossa s paper, like ours, models a counry s comparaive advanage drawing on he lieraure on he home marke effec afer Krugman (98), implying producion relocaion exernaliies associaed wih he expansion of manufacuring. 2 The mechanisms by which moneary policy may influence comparaive advanage are of course relevan also for sabilizaion policies relying on fiscal and financial insrumens. Taxes and subsidies may conribue o demand and markup sabilizaion, conaining he disorions due o nominal price sickiness and hus, according o our core argumen, misallocaion across secors. While, everyhing else equal, inefficien moneary sabilizaion (e.g., deriving from adoping a fixed exchange) may hamper comparaive advanage in manufacuring, subsiuion among policy insrumens may make up for 2 According o he home marke effec, he size of he marke (i.e. a high demand) is a source of comparaive advanage in manufacuring. In his lieraure, he social benefis from gaining comparaive advanage in he manufacuring secor sem from a producion relocaion exernaliy. In he presence of such an exernaliy, acquiring a larger share of he world producion of differeniaed goods produces welfare gains due o savings on rade coss. Our work is also relaed o Corsei e al. (27), which considers he role of he home marke effec in a real rade model, as well as Ghironi and Meliz (25). We differ in modeling economies wih wo radable secors, as well as considering he implicaions of price sickiness and moneary policy. 3

5 consrains on moneary policy. Our analysis shows a specific reason why exploiing a wide range of sabilizaion insrumens is paricularly valuable. The ex is srucured as follows. The nex secion describes he model, and secion 3 derives analyical resuls for a simplified version. Secion 4 uses sochasic simulaions o demonsrae a broader se of implicaions. Secion 5 concludes. 2. Model In wha follows, we develop a wo-counry moneary model, inroducing a key novel elemen in he way we specify he goods marke srucure. Namely, each counry home and foreign--- produces wo ypes of radable goods. The firs ype comes in differeniaed varieies produced under monopolisic compeiion. In his marke, firms face enry coss and nominal rigidiies. The second ype of good is produced by perfecly compeiive firms, and is modeled according o he sandard specificaion in real business cycle models. For his good, here is perfec subsiuabiliy among producers wihin a counry (indeed, he good is produced under perfec compeiion), bu imperfec subsiuabiliy across counries, as summarized by an Armingon elasiciy. In he ex we presen he households and firms problems as well as he moneary and fiscal policy rules from he vanage poin of he home economy, wih he undersanding ha similar expressions and consideraions apply o he foreign economy---foreign variables are denoed wih a. Also, in presening he model we focus on he case of balanced rade, which also provides he baseline for our simulaion---he bond economy case is presened in he appendix. 2.. Goods consumpion demand and price indexes Households consume goods from wo secors. The D secor consiss of differeniaed varieies of manufacuring good, which are produced by n and n monopolisically compeiive firms in he home and foreign counry, respecively (from now on, foreign variables will be denoed wih an aserisk). Each variey in he D secor is an imperfec subsiue for any oher variey in his secor, eiher of home or foreign origin, wih elasiciy ϕ. The N secor consiss of non-differeniaed goods, produced by perfecly 4

6 compeiive firms. The home and foreign versions of he N good are imperfec subsiues for each oher, wih elasiciy η. For convenience, hereafer we may refer o he firs secor as manufacuring. The overall consumpion index is specified: C C D, C N,, where n n CD, ch dh c f df is he index over he home and foreign varieies of manufacuring good, c(h) and c(f), and C N, C H, C F, is he index over goods differeniaed only by counry of origin, wih ν accouning for he weigh on domesic goods. The corresponding consumpion price index is where P P P D, N, D, 5, () P n p h n p f (2) is he index over he prices of all varieies of home and foreign manufacuring goods, and N H F P, P, P, (3) is he index over he prices of home and foreign non-differeniaed goods. These definiions imply relaive demand funcions for domesic residens: () / D, D, c h p h P C (4) ( ) / D, D, c f p f P C (5) C PC / P (6) D, D, N, N, C PC / P (7) H, H, / N, N, C P P C (8)

7 / C P P C. (9) F, F, N, N, 2.2. Home households problem The represenaive home household derives uiliy from consumpion (C), and from holding real money balances (M/P); i derives disuiliy from labor (l). The household derives income by selling labor a he nominal wage rae (W); i receives real profis from home firms as defined below, and ineres income (ib) on holding domesically raded bonds, which are in zero ne supply. I pays lump-sum axes (T). Household opimizaion for he home counry may be wrien: where uiliy is defined by subjec o he budge consrain: M max E UC, l, P M U C l ln P PC M M B i B Wl T. Above, σ denoes risk aversion and ψ he inverse of he Frisch elasiciy. Defining PC, opimizaion implies an ineremporal Euler equaion: a labor supply condiion: and a money demand condiion: i W E, () l () i M i. (2) The problem and firs order condiions for he foreign household are analogous Home firm problem and enry condiion in he differeniaed good secor In he differeniaed goods secor, producion is linear in labor: 6

8 7 D, y h l h, (3) where l(h) is he labor employed by firm h, and D is sochasic echnology common o all differeniaed goods producers in he counry. Expors involve an iceberg rade cos, D, so ha y h d h d h, (4) D where dh c( h) d AC, ( h) dk, ( h) is oal demand for he produc in he home counry, for use in consumpion, adjusmen coss, and enry coss, respecively; corresponding demand for home goods abroad. Firm profis are compued as: h p hd h e p hd h W y h/ AC h p, d h is he. (5) To se up a firm, managers incur a one-ime sunk cos, K, and producion sars wih a one-period lag. In each period, all firms operaing in he differeniaed good secor face an exogenous probabiliy of exi, so ha a fracion of all firms exogenously sop operaing each period. Thus he value funcion of firms ha ener he marke in period may be represened as he discouned sum of profis of domesic sales and expor sales, i, s s vh E sh, s and, wih free enry, new producers will inves unil he poin ha a firm s value equals he enry sunk cos. The sock of firms a each poin in ime is:. (6) We include a congesion exernaliy in he enry, represened as an adjusmen cos ha is a funcion of he number of new firms. ne K K. ne The congesion exernaliy plays a similar role as he adjusmen cos for capial sandard in business cycle models, which moderaes he response of invesmen o mach dynamics in daa. In a similar vein, we calibrae he adjusmen cos o mach daa on he dynamics of new firm enry. We generally specify enry coss as consising of labor unis and/or invesmen in differeniaed goods unis. The enry condiion may be wrien n n ne K K D v h W P K, (7)

9 where K = is he case of enry coss in labor unis, and K = is he case of goods unis. The goods componen of he enry cos falls on boh domesically produced and impored goods, in similar proporion as consumpion: d () h p h / P nek (8) K, D, K d ( f) p f / P nek. (9) K, D, K The home firm h ses a price p(h) in domesic currency unis for domesic sales. Under he assumpion of producer currency pricing, his implies a foreign currency price p h p h / e, (2) D where he nominal exchange rae, e, is defined as home currency unis per foreign currency uni. Firms face a nominal cos of adjusing prices h p h P ACh ph yh. (2) 2 p For he sake of racabiliy, we follow Bilbiie e al. (28) in assuming ha new enrans inheri from he price hisory of incumbens he same price adjusmen cos, and so make he same price seing decision. The aggregae value of he price adjusmen coss is: 2 To adjus heir price, firms use final goods according o: AC h n AC h. (22), () / AC M, AC, D, d h p h P D (23), ( ) / AC M, AC, D, d f p f P D (24) D PAC / P (25) AC, D, D, AC, N, N, D PAC / P (26) ACH,,, / H N, ACN,, D P P D (27) / AC, F, F, N, AC, N, D P P D. (28) similar o he composiion of equaions (4)-(9). Maximizing firm value subjec o he consrains above leads o he price seing equaion: 8

10 2 2 W p h p h p P h ph ph P 2 p h p h p h P E p h p h p h p h where he opimal pricing is a funcion of he sochasically discouned demand faced by producers of domesic differeniaed goods, p h CD, DAC, D, K nek P M,. Dph D C D, D ACD,, K nek. ep M, Noe ha, since households own firms, hey receive firm profis bu also finance he creaion of new firms. In he household budge, he ne income from firms may be wrien: 2 n h nev h. (29) 2.4. Home firm problem in he undiffereniaed good secor In he second secor firms are assumed o be perfecly compeiive in producing a good differeniaed only by counry of origin. The producion funcion for he home nondiffereniaed good is linear in labor: y l, (3) H, HH,, where H, is subjec o shocks. I follows ha he price of he homogeneous goods in he home marke is equal o marginal coss: p W /. (3) H, H, An iceberg rade cos specific o he non-differeniaed secor implies prices of he home good abroad are p H, p H, N / e. (32) Analogous condiions apply o he foreign non-differeniaed secor Moneary and fiscal policy 9

11 Moneary auhoriies are assumed o pursue an independen moneary policy, approximaed by he following Taylor rule: p Y p h Y i i. (33) p h Y In his rule, inflaion is defined in erms of differeniaed goods producer prices, while Y is a measure of oupu defined as: n Y p hyh dh phyh, / P. In running he model, we will use eiher he above or a narrower definiion of oupu, including only manufacuring. Given our calibraion of he Taylor rule, wih a high coefficien on inflaion, his will be immaerial for our resuls. In he foreign counry, moneary auhoriies will be assumed o pursue eiher a Taylor rule similar o (33) or, alernaively, an exchange rae peg: e e. (34) The model absracs from public consumpion expendiure, so ha he governmen uses seigniorage revenues and axes o finance ransfers, assumed o be lump sum. The home governmen faces he budge consrain: M M T. (35) 2.6. Marke clearing The marke clearing condiion for he manufacuring goods marke is given in equaion (4) above. Marke clearing for he non-differeniaed goods marke requires: Labor marke clearing requires: y C D C D (36) H, H, ACH,, N H, ACH,, y C D C D. (37) F, F, ACF,, N F, ACF,, Bond marke clearing requires: n lh dh lh, KneK l. (38) B. (39)

12 Under he assumpion of no inernaional rade in asses, inernaional rade in goods mus be balanced period by period: n n K AC K AC PH CH DAC, H, PF CF DAC, F,.,, p h c h d h d h dh p f c f d f d f df (4) 2.7. Shocks process and equilibrium definiion We will consider a number of shocks sudied in he lieraure, feauring shocks o produciviy, bu also including shocks o ineremporal consumpion preferences, money demand, and fiscal policy. Given he srucure of our economy, shocks are assumed o follow join log normal disribuions. In he case of produciviy, for insance, we can wrie: logd log D logd log D logd log D logd log D logh logh logh logh log log log log F F F F ' wih he covariance marix E. A compeiive equilibrium for he world economy presened above is defined along he usual lines, as a se of processes for quaniies and prices in he Home and Foreign counry saisfying: (i) he household and firms opimaliy condiions; (ii) he marke clearing condiions for each good and asse, including money; (iii) he resource consrains whose specificaion can be easily derived from he above and is omied o save space Relaive price and expor share measures Along wih he real exchange rae ( ep / P), we repor wo alernaive measures of inernaional prices. Firs, as is common pracice in he producion of saisics on inernaional relaive prices, we compue he erms of rade weighing goods wih heir respecive expendiure shares:

13 p H, TOTS p(h) H H, (4) F e p ( f ) F e p F, where he weigh H measures he share of differeniaed goods in he home counry s overall expors: and F p () h n c h d Kh d AC, h K AC, H H AC, H, H p h n c h d h d h P C D () measures he counerpar for he foreign counry: p( f) n c f dk f dac, f F p( f) n c f d f d f P C D K AC, F F AC, F,, (4a). (4b) Following he rade lieraure, we also compue he erms of rade as he raio of ex-facory prices se by home firms relaive o foreign firms in he manufacuring secor: ( )/ ( ) TOTM p h e p f. 3 The laer measure ignores he non-differeniaed good secor. 3. Analyical Insighs from a Simple Version of he Model In his secion, we provide a close up analysis of he mechanism by which moneary policy impinges on pricing by differeniaed good manufacures, ulimaely deermining he counry s comparaive advanage in he secor. To be as clear as possible, we work ou a simplified version of he model ha is amenable o analyical resuls. Despie a number of assumpions needed o make he model racable, he key predicions of he simplified model will be confirmed in our full-fledged version of he model. We specialize our model as follows. Firs, we posi ha enry coss are in labor unis, i.e., K =, and manufacuring firms operae for one period only (implying in he enry condiion), and symmerically prese prices over he same horizon. Second, we simplify he non-differeniaed good by seing is rade coss o zero ( N ) and le he elasiciy of subsiuion beween home and foreign goods approach infiniy ( ). This implies ha he secor produces a homogeneous good, an assumpion frequenly made in 3 This is he same definiion used in Ossa (2), hough in our case i does no imply he erms of rade are consan a uniy, because moneary policy does affec facory prices. See also Helpman and Krugman (989), and Campolmi e al. (24). 2

14 he rade lieraure. 4 Third, we resric produciviy shocks o be i.i.d., and only occur in he differeniaed good secor (we absrac from produciviy shocks in he non-differeniaed good secor). Fourh, uiliy is log in consumpion and linear in leisure ( ). Finally, drawing on he NOEM lieraure (see Corsei and Peseni 25, and Bergin and Corsei 28), we carry ou our analysis of sabilizaion policy by defining a counry s moneary sance as PC, under he conrol of moneary auhoriies via heir abiliy o se he ineres rae. Following his approach, we herefore sudy moneary policy in erms of (and for he foreign counry), insead of he ineres rae rule (33). Under hese assumpions---in paricular, using he fac ha he discoun rae for nominal quaniies can be wrien as he (inverse of he) growh rae of PC ---he firms problem becomes max p h E h. The opimal prese price in he domesic marke is: p h W E, (42) E where W is he firm s marginal coss, ha is, he raio of nominal wages o labor produciviy. In his simplified model seing, he sochasically discouned value of fuure demand facing he firm for is good in boh markes,, becomes: c h c h. 5 The home enry condiion is a funcion of price seing and he exchange rae: K E p h p h. (43) 4 Differen from he rade lieraure, however, we do rea his secor as an inegral par of he (general) equilibrium allocaion, e.g., expors/impors of he homogeneous good secor eners he erms of rade of he counry. 5 Upon appropriae subsiuions and cancellaions, equaion (42) may also be wrien wih defined as n p ( h) n p ( f) e n p ( h) n p ( f) e. 3

15 Provided ha he price seing rules can be expressed as funcions of he exogenous shocks and he moneary sance, he home and foreign equilibrium enry condiions along wih he exchange rae soluion above comprise a hree equaion sysem in he hree variables: e, n and n. This sysem admis analyical soluions for several configuraions of he policy rules. A noable propery of he simplified version of he model is ha, by he equilibrium condiion in he labor marke wih an infinie labor supply elasiciy, he exchange rae is a funcion of he raio of nominal consumpion demands, hence of he moneary policy sances. To see his, since boh economies produce he same homogeneous good wih idenical echnology under perfec compeiion, and his good is raded coslessly across borders, arbirage ensures ha P e P D D. The exchange rae can hen be expressed as: e p D W p D W PC P C, (44) where we have used he labor supply condiion () imposing linear preferences in leisure ( ). Given symmeric echnology in labor inpu only, he law of one price implies ha nominal wages are equalized (once expressed in a common currency) across he border The equilibrium consequences of nominal rigidiies A he core of our resuls is a general propery of sicky price models ha is bes exemplified in our simplified model. Rewrie (42) as follows: W Cov W p h E E' (42 ) 6 A special implicaion of nominal wage equalizaion (due o rade in a single homogenous good whose producion is no subjec o shocks), is ha producion risk is efficienly shared, even in he absence of rade in financial asses, and independenly of he way producion and rade are specified in he oher secor. To see his, jus rewrie equaion (44) as he sandard perfec risk sharing condiion: ep C rer. P C Home consumpion rises relaive o foreign consumpion only in hose saes of he world in which is relaive price (i.e. he real exchange rae) is weak. 4

16 By he covariance erm on he righ-hand side of his expression, he opimal prese price is a funcion of he comovemens of a firm s marginal coss ( W ), and overall (domesic and foreign) demand for he firm s good,. To appreciae he relevance of his propery for he moneary ransmission mechanism, consider he exreme case of no moneary sabilizaion of business cycle flucuaion, i.e., posi ha he moneary sance does no respond o any shock, bu arge a consan nominal demand in eiher counry ( ). This implies a consan nominal exchange rae a e and, wih i.i.d. / shocks, no dynamics in predeermined variables such as prices and numbers of firms. Under hese moneary rules, he opimal prese prices (42 ) simplify o no sab p h E no sab p f E, ha is, prices are equal o he expeced marginal coss (coinciding wih he inverse of produciviy) augmened by he equilibrium markup. Mos criically, under a consan moneary sance, hese opimal pricing decisions do no depend on he erm Ω (hence do no vary wih rade coss and firms enry), as hey do in he general case. The number of firms can be compued by subsiuing hese prices ino he enry condiion (43), so o obain: n n. q no sab no sab Inuiively, given consan moneary sances, here is no change in he exchange rae. Wih prese prices, a shock o produciviy will have no effec on he erms of rade, he real exchange rae, hence here will be no change in consumpion demands and producion for eiher ype of good. Wih no moneary response, an i.i.d. shock raising produciviy in he home manufacuring secor necessarily leads o a fall in he level of employmen in he same secor (no compensaed by a change in employmen in he oher secors of he economy). Firms end up producing a low marginal coss and hus sub-opimally high markups, since nominal rigidiies preven firms from re-pricing and scaling down producion. Conversely, given nominal prices and demand, a drop in produciviy will cause firms o produce oo much a high marginal coss, hence a sub-opimally low markups. So, in a regime of no oupu gap sabilizaion, firms face random realizaions of inefficienly high and inefficienly low levels of producion and markup. When preseing 5

17 prices, managers maximize he value of heir firm by rading off higher markups in he low produciviy sae, wih lower markups in he high produciviy saes. In our model above, hey weigh more he risk of producing oo much a high marginal coss: i is easy o see ha prese prices are increasing in he variance of produciviy shocks (by Jensen s inequaliy, E E ). 7 Since boh marginal coss and overall demand are funcions of moneary sances, in he general case policy regimes can criically impinge on pricing (and hus on enry) via he covariance erm in he equaion. The implicaions for our argumen are deailed nex Prices and firm dynamics under efficien and inefficien sabilizaion of oupu gaps Suppose ha he moneary sance in each counry moves in proporion o produciviy in he differeniaed good secor:,. The exchange rae in his case is no consan, bu coningen on produciviy differenials, so ha he home currency sysemaically depreciaes in response o an asymmeric rise in home produciviy: e. I is easy o see ha, by ensuring ha he nominal marginal coss μ/α remain consan, he above policy zeroes he covariance erm in (see (42 )), and hus insulaes he ex-pos markup charged by home manufacuring firms from uncerainy abou produciviy. 8 Noe ha, o he exen ha moneary policy sabilizes marginal coss compleely, i also sabilizes markups a heir flex-price equilibrium level. I follows ha he price firms prese is lower han in an economy wih no sabilizaion: 7 As discussed in Corsei and Peseni (25) and Bergin and Corsei (28) in a closed economy conex, given nominal demand, high prese prices allow firms o conain overproducion when low produciviy squeezes markups, rebalancing demand across saes of naure. High average markups, in urn, exacerbae monopolisic disorions and end o reduce demand, producion and employmen on average, discouraging enry. 8 As is well undersood, he policy works as follows: in response o an incipien fall in domesic marginal coss domesic demand and a real depreciaion boos foreign demand for domesic produc. As nominal wages rise wih aggregae demand, marginal coss are compleely sabilized a a higher level of producion. Vice versa, by curbing domesic demand and appreciaing he currency when marginal coss are rising, moneary policy can preven overheaing, driving down demand and nominal wages. Again, marginal coss are compleely sabilized as a resul. 6

18 p h p h E. sab no sab In a muli-secor conex, a key effec of moneary sabilizaion is ha of reducing a counry s differeniaed goods price in erms of domesic nondiffereniaed goods, redirecing demand across secors. This rise in demand for differeniaed goods suppors he enry of addiional manufacuring firms. Since he model posis ha he homogenous good secor operaes under perfec compeiion and flexible prices, here is no rade-off in sabilizing oupu across differen secors. I is herefore possible o replicae he flex-price allocaion under a moneary policy rule ha sabilizes markups in he differeniaed secor. As shown in he appendix, under his rule he number of manufacuring firms is: 9 n sab 2 q E he same as under flexible prices. Consider insead he case in which, while he home governmen keeps sabilizing is oupu gap, he foreign counry swiches moneary regime o a currency peg: and e, so ha. Under he policy scenario jus described, he opimally prese prices of domesically and foreign produced differeniaed goods are, respecively: p h, p f E. 2( ) 9 As discussed in he appendix, i is no possible o deermine analyically wheher symmeric sabilizaion policies raise he number of firms compared o he no sabilizaion case. Model simulaions sugges ha here is no posiive effec for log uiliy, and a small posiive effec for CES uiliy wih a higher elasiciy of subsiuion. Noneheless, we are able o provide below an analyical demonsraion of asymmeric sabilizaion, which is our main objecive. The above generalizes o our seup a familiar resul of he classical NOEM lieraure (wihou enry) assuming ha prices are sicky in he currency of he producers (Corsei and Peseni (2, 25) and Devereux and Engel (23), among ohers): despie nominal rigidiies, policymakers are able o sabilize he oupu gap relaive o he naural-rae, flex-price allocaion. A relaed exercise consiss of assuming ha he foreign counry keeps is money growh consan ( ) while home carries ou is sabilizaion policy as above. 7

19 While he home policy makers manage o sabilize he markup of manufacuring firms compleely, he foreign firms producing under he peg regime face sochasic marginal coss/markups driven by shocks o produciviy, boh domesically and abroad. Wih i.i.d. shocks, prese prices will be increasing in he erm E (/α + ), as in he no sabilizaion case. While i is no possible o solve for he number of firms in closed form, as shown in he appendix i is possible o prove ha n>n flex > n Oher hings equal, he consrain on macroeconomic sabilizaion implied by a currency peg ends o reduce he size of he manufacuring secor in he foreign counry: here are fewer firms, each charging a higher price. The home counry s manufacuring secor correspondingly expands. In oher words, he counry pegging is currency ends o specialize in he homogeneous good secor. To fix ideas: insofar as he foreign peg resuls in higher relaive prices in he foreign manufacuring secor, inefficien sabilizaion redirecs demand owards he (now relaively cheaper) non-differeniaed good secor. Mos crucially, as he raio of he counry s differeniaed goods prices o nondiffereniaed goods prices rises compared o he home counry, he foreign comparaive advanage in he secor weakens: domesic demand shifs owards differeniaed impors from he home counry. Because of higher monopolisic disorions and he higher rade coss in impors of differeniaed goods, foreign consumpion falls overall (in line wih he predicions from he closed economy one-secor counerpar of our model, e.g., Bergin and Corsei 28). All hese effecs combined reduce he incenive for foreign firms o ener in he differeniaed good secor. The counry s loss of compeiiveness is mirrored by a rend appreciaion of is welfare-relevan real exchange rae, mainly due o he fall in varieies available o he consumers. Bu real appreciaion is acually associaed wih weaker, no sronger, erms of rade. Weaker erms of rade follow from he change in he composiion of foreign producion and expors, wih more weigh aached o low value added non-differeniaed goods. The consequences of a foreign peg on he home economy are specular. The home counry experiences a surge of world demand for is differeniaed good producion, while sronger erms of rade boos domesic consumpion. More firms ener he manufacuring 8

20 secor, leading o a shif in he composiion of is producion and expors in favor of his secor. As a resul, wih a foreign counry passively pegging is currency, here are exra benefis for he home counry from being able o pursue sabilizaion policies. The home manufacuring secor expands driven by higher home demand overall, and fills par of he gap in manufacuring producion no longer supplied by foreign firms. A he same ime, he shifing paern of specializaion ensures ha he home demand for he homogeneous good is saisfied via addiional impors from he foreign counry. 4. Numerical simulaions In his secion, we evaluae he quaniaive implicaions of our full model, by conducing sochasic simulaions. Despie he many differences beween he simplified and he full version of our model, we will show ha he key resuls from he former coninue o hold in he laer. Namely, in our general specificaion i will sill be rue ha, if he foreign counry moves from efficien sabilizaion o a peg, while he home counry sicks o efficien sabilizaion rules, (a) he foreign average markups and prices in manufacuring will end o increase and (b) here will be producion relocaion---firm enry in he foreign counry will fall on average, while enry in he home counry will rise on average. Correspondingly, average consumpion will rise a home relaive o foreign. We will also show ha his relocaion will be associaed wih an average improvemen in he home erms of rade (while he home welfare-relevan real exchange rae depreciaes). To illusrae he core properies of he model, we iniially assume ha produciviy shocks are he only source of uncerainy, and discuss heir effecs in a number of varians of he model relaive o our baseline specificaion. Afer showing he impulse responses generaed by flucuaions in manufacuring produciviy, we will discuss he effec of produciviy uncerainy on he uncondiional means of macroeconomic variables, drawing from sochasic simulaions of a second order approximaion of he model. In a final subsecion, we include in he model addiional sources of uncerainy, considering a number of shocks sudied in he lieraure. Throughou our experimens, we conras wo policy scenarios: symmeric oupu sabilizaion policies versus asymmeric sabilizaion, 9

21 wih he foreign counry auhoriies pegging o he home counry. We sar wih our calibraion of he model, discussed nex. 4.. Parameer values Parameer values are chosen o be consisen wih an annual frequency---he frequency a which secoral produciviy daa are available. We se ime preferences a.96 ; risk aversion a he sandard value of 2 ; labor supply elasiciy a /.9 following Hall (29), hough we will check for sensiiviy of our resuls o his parameer. The price sickiness parameer is se a p 8.7, a modes value which in a Calvo seing would correspond o half of firms reseing price on impac of a shock, wih 75 percen reseing heir price afer one year. 2 The deah rae is se a., which is four imes he sandard rae of.25 o reflec he annual frequency. The sunk cos of enry is normalized o he value. To choose parameers for he differeniaed and non-differeniaed secors we draw on Rauch (999). We choose so ha differeniaed goods represen 57 percen of U.S. rade in value. 3 The home share of non-differeniaed goods is se a.5, which implies a rade share of abou 3%, given he rade coss and elasiciies below. To se he elasiciies of subsiuion for he differeniaed and non-differeniaed goods we draw on he esimaes by Broda and Weinsein (26), classified by secors based on Rauch (999). The Broda and Weinsein (26) esimae of he elasiciy of subsiuion beween 2 As is well undersood, a log-linearized Calvo price-seing model implies sochasic difference equaion for inflaion of he form E mc, where mc is he firm s real marginal cos of producion, and where q q/ q, wih q is he consan probabiliy ha firm mus keep is price unchanged in any given period. The Roemberg adjusmen cos model used here gives a similar log-linearized difference equaion for inflaion, bu wih /. Under our parameerizaion, a Calvo probabiliy of q =.5 implies an adjusmen cos parameer of 8.7. This compuaion is confirmed by a sochasic simulaion of a permanen shock raising home differeniaed goods produciviy wihou inernaional spillovers, which implies ha price adjuss 5% of he way o is long run value immediaely on impac of he shock, and 75% a one period (year in our case) afer he shock. 3 Values vary by year and by wheher a conservaive or liberal aggregaion is used. Taking an average over he hree sample years and he wo aggregaion mehods repored in Table 2 of Rauch (999) produces an average of.57. Replicaing his value in our seady sae requires a calibraion of he consumpion share a =.38, which compensaes for he fac ha rade for invesmen purposes (sunk cos) involves differeniaed goods only. 2

22 differeniaed goods varieies is =5.2 (he sample period is ). The corresponding elasiciy of subsiuion for nondiffereniaed commodiies is = 5.3. To se rade coss, we need o hink beyond coss associaed wih jus ransporaion. These are ofen hough o be higher for commodiies han for high-value differeniaed goods. As Rauch (999) poins ou, differeniaed goods involve search and maching coss, whereas commodiies and goods raded on an organized exchange wih a published reference price avoid such coss. Esimaes are available for he ariff equivalen of language coss, wih a value of % in Hummels (999) or 6% in Anderson and van Wincoop (24), so we use 8% in beween. Since Obsfeld and Rogoff (2) recommend a calibraion of oal rade coss a 6%, our calibraion implies ha half of his is due o language and maching coss, and he oher half due o ransporaion. This implies a calibraion of D =.6 for differeniaed goods, and N =.8 for non-differeniaed goods. The parameers in he home moneary policy rule are deermined by he values ha maximize home uiliy. As ypically found, he opimal weigh on inflaion is he maximum value considered in he grid search ( P =), and he opimal value on oupu is Y =. The foreign counry is assumed o peg is exchange rae a pariy wih he home counry: e=. To our knowledge, no one else has calibraed a DSGE model wih secoral shocks disinc o differeniaed and nondiffereniaed goods. Annual ime series of secoral produciviies are available from he Groningen Growh and Developmen Cenre (GGDC), for he period Daa for he U.S. is used o parameerize shocks o he home counry, and an aggregae of he EU for he foreign counry. 4 TFP is calculaed on a value-added basis. For each counry, he differeniaed goods secor comprises oal manufacuring excluding wood, chemical, minerals, and basic meals; he nondiffereniaed goods secor comprises agriculure, mining, and subcaegories of manufacuring excluded from he differeniaed secor. To calculae he weigh of each subsecor wihin he differeniaed (or non-differeniaed) secor, we use he 995 gross value added (a curren prices) of each subsecor divided by he oal value added for he differeniaed (or non-differeniaed) secor. Afer aking logs of he weighed series, we de- 4 These EU counries are AUT, BEL, DNK, ESP, FIN, FRA, GER, ITA, NLD and he UK. See hp:// 2

23 rend each series using he HP filer. Parameers and Ω, repored in Table, are obained from running a VAR() on he four de-rended series. The benchmark simulaion model specifies enry coss in unis of goods ( K =) bu we will also repor resuls for enry coss in labor unis in our sensiiviy analysis (see he discussion in Cavallari 23). The adjusmen cos parameer for new firm enry,, is chosen o mach he sandard deviaion of new firm enry in he benchmark simulaion o ha in daa. The World Bank s Enrepreneurship Survey and daa base provides a coun of new businesses regisered during a calendar year, for he period 24 o 22 for seleced counries. We use he daa available for France, Germany, Ialy and he U.K. o represen he foreign counry in our model. Daa for he U.S. on esablishmen enry are available from he Longiudinal Business Daabase. Sandard deviaions for logged and HP-filered series are repored as raios o he sandard deviaion of GDP for he same period: he value for he U.S. is 5.53, and he European average is 3.. A value of =.25 in he simulaion model, wih he remaining parameers and shocks as described above, generaes sandard deviaions of new firm enry close o hese values. (See Table 2b.) 4.2. Simulaion resuls Impulse responses Figure repors he dynamics of he benchmark model in response o a one sandard deviaion posiive shock o produciviy in he differeniaed goods secor of he home counry, where boh counries employ efficien sabilizaion policy. The figure plos he percenage deviaion from he uncondiional mean of key variables of ineres. As home policymakers fully sabilize he markup, hey reac o he shock by expanding domesic demand and depreciaing he exchange rae. This policy reacion booss producion in he differeniaed secor, in line wih is enhanced produciviy. The number of firms in he secor rises, and producion shifs in favor of home differeniaed goods, away from nondiffereniaed goods. In he foreign counry, he shif in producion paern parly reflecs he cross-counry auocorrelaion of shocks in he calibraion. Since he foreign counry also experiences a rise in differeniaed goods produciviy, he number of firms and he volume of differeniaed oupu also rise in his counry, hough by a smaller magniude han a home where he shock originaed, and wih a one period lag. 22

24 To furher clarify he role of he cross-counry correlaion of shocks, in Figure 2 we redo he analysis by seing he cross-counry elemens of he shock auorcorrelaion marix equal o zero. This figure hus shows he effecs of a rise in he differeniaed goods produciviy a home ha remains asymmeric. Foreign producion of differeniaed goods falls (while i rises a home); conversely foreign producion of nondiffereniaed goods rises (while i falls a home). The case of asymmeric policies---wih he foreign counry pegging is exchange rae, and he home counry employing efficien sabilizaion policy---is shown in he nex wo figures. In response o a favorable shock o home differeniaed-goods produciviy, he behavior of home variables in Figure 3 is very similar o Figure. Bu in Figure 3, he response of he foreign variables closely resembles hose of he home variables. The commimen o exchange rae sabiliy causes he foreign moneary auhoriies o expand money supply and demand by more, in sep wih he home counry, providing exra simulus o he foreign differeniaed goods secor a he expense of he nondiffereniaed goods secor. Figure 4 shows he effecs of a produciviy shock o he differeniaed goods secor in he counry pursuing a peg (ha is, foreign). I differs noiceably from he oher figures. In he absence of a sabilizing policy response, manufacuring enry in he foreign economy, while posiive, is an order of magniude smaller compared o enry in he home economy in he previous figures. Likewise, he rise in foreign producion of differeniaed goods is much smaller and much shorer lived Uncondiional means Table 2a repors he uncondiional means of key variables obained from sochasic simulaions of a second order approximaion of he benchmark model, and Table 2b repors sandard deviaions. In Column () of Table 2a boh counries use sabilizaion policy, while in column (2) he foreign counry adops an exchange rae peg. Column (3) repors he percen change beween he previous columns, hence accouning for changes when he foreign counry pursues a peg insead of inflaion sabilizaion. Noe ha counry means in column () are no compleely symmeric despie symmeric policies, due o he crossborder differences in he esimaed TFP shock process. 23

25 The simulaion resuls fully confirm he main analyical insighs from he previous secion. When he foreign counry pegs, average producion of he differeniaed good shifs away from he foreign counry and oward he home counry; he foreign counry insead has higher producion of he non-differeniaed good. This shif in producion is refleced in a.73 percen fall in he number of foreign differeniaed goods firms, in conras o a.63 percen rise a home: he raio of foreign firms relaive o he home counerpar falls.36 percen. The share of differeniaed goods in expors ( F ) falls by.56 percen in he foreign counry, while he share in he home counry ( H ) rises by.6 percen. This implies ha he raio of he foreign expor share relaive o he home counerpar falls.7 percen. Also consisen wih he ransmission mechanism discussed in he previous secion, wha drives he foreign loss in he differeniaed goods marke share under a peg is he higher average markup charged by foreign producers of hese goods. Noe ha he foreign price of differeniaed goods rises relaive o boh wages and non-differeniaed goods (.7 percen in boh cases). Finally, when he foreign policymaker abandons efficien sabilizaion policy for a peg, he foreign erms of rade including he homogenous good, TOTS, acually worsen (.38 percen). This sands in conras wih he movemens in he (convenionally-defined) erms of rade including only differeniaed goods, TOTM, which remains nearly unchanged (. percen). The differen behavior of he TOTS and TOTM is due o a composiion effec: he shif in foreign expor share away from differeniaed goods means hese more expensive goods receive a smaller weigh in he average price of foreign expors and a larger weigh in he average price of foreign impors. Inernaional price adjusmen highlighs a noable difference beween he simplified and he full model. As our resuls in Table 2a emphasize, despie a lower markup, he erms of rade of manufacuring do no necessarily fall wih beer sabilizaion. This will be so because, in he full model, a high level of enry ends o raise producion coss, as on average wages respond o a higher demand for domesic labor. To he exen ha labor supply is no infiniely elasic (as assumed in he simplified model), his effec may become srong enough o preven he inernaional price of domesic manufacuring from falling in andem wih average markup in he secor. 24

26 Table 2b shows ha he calibraion of our model is in line wih he volailiy of oupu in he US and he EU- counries, as well as he volailiies of key variables (in raio o he volailiy of oupu), such as consumpion, employmen and ne business formaion Alernaive model specificaions Table 3 summarizes our resuls under alernaive model specificaions. To save space, we only repor he percenage change in number of firms and percen change in differeniaed expor share when he foreign counry swiches from inflaion sabilizaion o exchange rae peg. The firs column repeas for comparison he key resul for he benchmark case from Table 2a. This resul depends compleely upon free enry of firms: Column (2) shows ha he changes in differeniaed expor share disappear when he number of firms is held fixed exogenously. The endogenous shif in number of firms beween counries is essenial for he change in moneary policy o ranslae ino quaniaively meaningful effecs on expor shares. The currency in which expor prices are sicky, wheher in unis of he producer or local currency, is no consequenial o he effec of policy on produc specializaion. When he price adjusmen specificaion of he benchmark model is replaced by he local currency version (he LCP version of Roemberg pricing is deailed in he appendix) resuls are nearly unchanged, as repored in column (3). Even if prices are inelasic o he exchange rae in he shor run, hey are ex-ane sensiive o he covariance of marginal coss and demand, which is he core mechanism by which moneary sabilizaion impinges on compeiiveness. The resul is also robus o relaxing he requiremen ha rade is balanced. The appendix liss equaions for a version of he model which includes inernaional rade in nonconingen bonds, which can be used o finance emporary curren accoun imbalances in response o shocks. Column (4) of he able shows ha he effec of he peg on relaive firm enry and expor share is similar o ha under balanced rade, and even slighly magnified. This resul is somewha sronger, when we allow for sickiness in wages as well as prices. In he version of he model simulaed in column (5) of he able, we allow for 25