Trade, Unemployment, and Monetary Policy

Abstract

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