Date: 2012-09-01

Creator: Yao Tang, Ke Pang

Access: Open access

We compare the welfare of different combinations of monetary and currency policies in an open-economy macroeconomic model that incorporates two important features of many small economies: a high level of vertical international trade and a prevalent use of a large trade partner's currency as the invoicing currency for both imports and exports. In this environment, a small economy prefers a fixed exchange rate regime over a flexible regime, while the larger economy prefers a flexible exchange rate regime. There are two main causes underlying our results. First, in the presence of sticky prices, relative prices adjust through changes in the exchange rate. Multiple stages of production and trade make it more difficult for one exchange rate to balance the whole economy by adjusting several relative prices throughout the vertical chain of production and trade. Namely, there is a trade-off between delivering an efficient relative price between home and foreign final goods and delivering an efficient relative price between home and foreign intermediate goods. Second, because the small economy uses the larger economy's currency in trade, it faces a high degree of exchange rate pass-through under a flexible regime and hence suffers from the lack of efficient relative prices in vertical trade. The larger economy, however, does not face this problem because its level of exchange rate pass-through is low.

Date: 2013-10-28

Creator: Yao Tang, Yoshinori Kurokawa, Jiaren Pang

Access: Open access

We construct a dynamic Ricardian model of trade with money and nominal exchange rate. The model implies that the nominal wages of the trading countries are more likely to exhibit stronger positive comovements when the countries fix their bilateral exchange rates. Panel regression results based on data from OECD countries from 1973 to 2012 suggest that countries in the European Monetary Union (EMU) experienced stronger positive wage comovements with their main trade partners. When we restrict the regression to the subsample of the EMU countries, we find a significant increase in wage comovements after these countries joined the EMU in 1999 compared to the pre-euro era. In comparison, when the sample is restricted to the non-EMU countries, we find no evidence that non-currency union pegs affected the wage comovements.