DP14952 Trade, Unemployment, and Monetary Policy

Author(s): Matteo Cacciatore, Fabio Ghironi
Publication Date: June 2020
Keyword(s): Optimal monetary policy, trade integration
JEL(s): E24, E32, E52, F16, F41, J64
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14952

We study how trade linkages affect the conduct of monetary policy in a two-country model with heterogeneous firms, endogenous producer entry, and labor market frictions. We show that the ability of the model to replicate key empirical regularities following trade integration---synchronization of business cycles across trading partners and reallocation of market shares toward more productive firms---is central to understanding how trade costs affect monetary policy trade-offs. First, productivity gains through firm selection reduce the need of positive inflation to correct long-run distortions. As a result, lower trade costs reduce the optimal average inflation rate. Second, as stronger trade linkages increase business cycle synchronization, country-specific shocks have more global consequences. Thus, the optimal stabilization policy remains inward looking. By contrast, sub-optimal, inward-looking stabilization---for instance too narrow a focus on price stability---results in larger welfare costs when trade linkages are strong due to inefficient fluctuations in cross-country aggregate demand.