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Vertical Trade, Exchange Rate Pass-Through, and the Exchange Rate Regime


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 open economies: a high level of vertical international trade and a high degree of exchange rate pass-through. 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 simultaneously throughout the vertical chain of production and trade. More specifically, there is a tradeoff 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 faces a high degree of exchange rate pass-through under a flexible regime, it suffers from a 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.

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  1. An alternative measurement of vertical trade is the production-sharing intensity of trade, defined as the ratio of affiliate sales of manufactured goods to the U.S. parent as a share of total manufacturing exports to the United States in a country (or region). Based on trade flows between U.S. multinationals and their affiliates, Burstein et al. (2008) reported that the production-sharing intensity of trade was approximately 50 % for Canada and 25 % for Mexico in 2003. When maquiladoras were included, the production-sharing intensity of trade increased dramatically from 25 % to 55 % for Mexico. As the authors explained in their paper, these data likely understated the degree of production sharing because they captured only intra-firm trade and omitted arm’s-length production sharing.

  2. Up to 2004, there were fifteen member states in the EU: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherland, Portugal, Spain, Sweden, and the United Kingdom. Out of them, the most important trading partner with the CEECs has been Germany, which accounted for 39.4 % of CEEC total parts imports and 49.7 % of their total parts exports.

  3. Kaminski and Ng (2001) focused on ten CEECs: the Czech Republic, Estonia, Hungary, Poland, Slovenia, Bulgaria, Romania, Slovakia, Latvia, and Lithuania.

  4. To facilitate the comparison of our results with those of the standard new open-economy macroeconomic models, we assume that the financial market is complete and that a production subsidy exists in each stage of production. Consequently, we abstract away from distortions caused by incomplete international risk-sharing and monopolistic competition and focus on a single friction: nominal price rigidity.

  5. Corsetti and Pesenti (2007) provided a graphical representation of optimal monetary policy in open economy models.

  6. However, depending on the model setup and types of shocks, LCP does not always imply that a fixed exchange rate regime is strictly preferred, e.g., Devereux et al. (2006) and Tille (2002).

  7. As we will discuss in details in Section 5, introducing labor mobility is unlikely to affect our results because migration is unlikely to affect the presence of vertical trade, a critical feature necessary for our results.

  8. Our results will hold in an infinite horizon model because of complete risk-sharing and price stickiness.

  9. For detailed derivation of the risk-sharing condition, see Devereux and Engel (2003) and Chari et al. (2002).

  10. Notice that although the price markup is the same for all goods produced at different stages and in different countries, PPP does not generally hold in our model because home firms practice LCP and set different prices in advance for home and foreign markets based on their expected demand in the corresponding market.

  11. We have assumed that no capital is required in either stage of production. Because there is no saving-investment decision in a one-period model, capital would be given exogenously in our simple model. Although the initial level of capital stock may have some impact on welfare, this is not an interest of this paper.

  12. We ignore the reverse of case (2), which is that the foreign country pegs unilaterally to the home currency. This is because the foreign economy is much larger in size, and it would not be optimal for the foreign country to engage in a unilateral peg.

  13. Benigno (2004) showed that, if two regions in a currency union have the same degree of nominal rigidity, it is optimal for the central bank to target the average inflation rate weighted by the economic sizes of the two regions. In practice, the European Monetary Union targets the average CPI of member countries, weighted by their consumption shares.

  14. The need for a second-order accurate solution in welfare analysis has been well addressed in the literature. For example, see Collard and Juillard (2001), Kim and Kim (2003), and Schmitt-Grohe and Uribe (2004).

  15. This solution technique has been employed in a series of papers, e.g., Sutherland (2004) and Senay and Sutherland (2005). The technical appendix (available upon request) documents the complete log-linearized system.

  16. The size of the home country does not affect our main results. For all n ≤ 0. 5, the results are qualitatively the same and available upon request.

  17. Ruhl (2008) reconciled the difference by suggesting that in the international macroeconomics literature, the smaller values of 𝜃 correspond to the responses of quantities to transitory shocks, while the larger estimates in the trade literature often rely on responses of quantities to permanent changes in tariff and trade cost.

  18. The literature suggests the relevant range for 𝜖 is [1,25]. We plot welfare for 𝜖 in [1,10] because we want to illustrate clearly the welfare comparison at lower values of 𝜖 and because the welfare ranking of the three regimes for all 𝜖 in [10,25] is the same as that for 𝜖 = 10.

  19. Detailed figures are in the technical appendix (available upon request).

  20. Another necessary feature is a high degree of exchange rate pass-through. Labor mobility is unlikely to change the choice of pricing currency, hence allowing for labor mobility would not affect the degree of exchange rate pass-through or our main results.


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Correspondence to Ke Pang.

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We are grateful to SSHRC, Wilfrid Laurier University, and Bowdoin College for financial support. We thank the anonymous referee and the editor for insightful suggestions. We also thank Shutao Cao, Julian Diaz, Wei Dong, Kevin Huang, Larry Schembri, Pierre Siklos, Jian Wang, and seminar participants at the Canadian Economic Association Meeting in Ottawa, Shanghai University of Finance and Economics, Wilfrid Laurier University, and Zhejiang University for helpful comments.

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Pang, K., Tang, Y. Vertical Trade, Exchange Rate Pass-Through, and the Exchange Rate Regime. Open Econ Rev 25, 477–520 (2014).

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  • Vertical production and trade
  • Exchange rate pass-through
  • Monetary policy

JEL Classifications

  • F3
  • F4