Does Trade Integration Alter Monetary Policy Transmission?

40 Pages Posted: 22 Nov 2010

See all articles by Tobias J. Cwik

Tobias J. Cwik

Board of Governors of the Federal Reserve System

Gernot J. Müller

University of Tuebingen - Department of Economics

Maik H. Wolters

Kiel Institute for the World Economy - IFW

Multiple version iconThere are 2 versions of this paper

Date Written: September 2010

Abstract

This paper explores the role of trade integration - or openness - for monetary policy transmission in a medium-scale new Keynesian model. Allowing for strategic complementarities in price-setting, we highlight a new dimension of the exchange rate channel by which monetary policy directly impacts domestic inflation: a monetary contraction which appreciates the exchange rate lowers the local currency price of imported goods; this, in turn, induces domestic producers to lower their prices too. We pin down key parameters of the model by matching impulse responses obtained from a vector autoregression on time series for the US relative to the euro area. Our estimation procedure yields plausible parameter values and suggests a strong role for strategic complementarities. Counterfactual simulations show that openness alters monetary transmission significantly. While the contractionary effect of a monetary policy shock on inflation and output tends to increase in openness, we find that monetary policy's control over inflation increases, as the output decline which is necessary to bring about a given reduction of inflation is smaller in more open economies.

Keywords: exchange rate channel, monetary policy transmission, open economy, strategic complementarity, trade integration

JEL Classification: E52, F41, F42

Suggested Citation

Cwik, Tobias J. and Müller, Gernot J. and Wolters, Maik H., Does Trade Integration Alter Monetary Policy Transmission? (September 2010). CEPR Discussion Paper No. DP8026. Available at SSRN: https://ssrn.com/abstract=1711019

Tobias J. Cwik (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue
Washington, DC 20551
United States

HOME PAGE: http://www.federalreserve.gov/econresdata/tobias-cwik.htm

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Maik H. Wolters

Kiel Institute for the World Economy - IFW ( email )

United States

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