Productivity Shocks and Monetary Policy in a Two-Country Model

• Published in: Frontiers of economics in China Vol. 10; no. 1; pp. 7 - 37
• Main Authors: Jang, Tae-Seok, Okano, Eiji
• Format: Journal Article
• Language: English
• Published: Beijing Higher Education Press 01.03.2015; Higher Education Press Limited Company
• Subjects: Analysis; cost channel; Economic aspects; Inflation; International trade; Keynesian economics; Keynesian theory; Monetary policy; Monopolistic competition; New Keynesian model; Open economy; Productivity; productivity shocks; Studies; Supply shocks; terms of trade; two-country model; 传输通道; 国际贸易; 垄断竞争; 开放型经济; 生产率; 货币政策; 贸易条件; 通货膨胀; China
• ISSN: 1673-3444; 1673-3568
• DOI: 10.3868/s060-004-015-0002-8

In this paper, we examine the effects of foreign productivity shocks on monetary policy in a symmetric open economy. Our two-country model incorporates the New Keynesian features of price stickiness and monopolistic competition based on the cost channel of Ravenna and Walsh （2006）. In particular, in response to asymmetric productivity shocks, firms in one country achieve a more efficient level of production than those in another economy. Because the terms of trade are directly affected by changes in both economies＇ output levels, international trade creates a transmission channel for inflation dynamics in which a deflationary spiral in foreign producer prices reduces domestic output. When there is a decline in economic activity, the monetary authority should react to this adverse situation by lowering the key interest rate. The impulse response function from the model shows that a productivity shock can cause a real depreciation of the exchange rate when economies are closely integrated through international trade.