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The International Transmission of Monetary Policy in a Dollar Pricing Model

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Abstract

This paper analyses the international transmission of monetary policy in the case where all export prices are set in US dollars. “Dollar pricing” implies that the international effects of US monetary shocks are different from those of European shocks because of an asymmetric exchange rate pass-through to import prices. A dollar pricing model can explain the observed asymmetry in the transmission of monetary policy: US monetary policy affects US output more than European monetary policy affects European output. I also show that the current account is an important channel through which monetary policy affects welfare. The paper concludes that under dollar pricing a monetary expansion is a beggar-thy-neighbour policy.

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Notes

  1. Lane (2001) provides an extensive survey of the NOEM literature. Lane and Ganelli (2003) focus on the exchange rate pass-though debate and the role of the current account and net foreign assets in adjustment dynamics.

  2. Engel (2002), Obstfeld (2002) and Obstfeld and Rogoff (2000b) discuss how low pass-through of exchange rate changes to consumer prices affect the expenditure switching effect of a nominal exchange rate change.

  3. The assumption of dollar pricing is also used in the papers by Devereux et al. (2003, 2007) and Corsetti and Pesenti (2005). These papers, however, do not address the topic of this paper.

  4. In this paper, in contrast to Schmidt (2006), there is no home bias in consumption, I abstract from capital formation, there is only one internationally traded asset, and the elasticity of substitution between goods produced in the same country is the same as the elasticity of substitution between goods produced in different countries.

  5. On the other hand, De Grauwe and Costa Storti (2005) reject the hypothesis that the short-run output effects of monetary policy in the Eurozone are lower than in the US.

  6. As mentioned in the introduction, the model is based on Betts and Devereux (2000).

  7. In the presentation of the model that follows, the equations for the foreign country are identical to those of the home country unless they are explicitly discussed.

  8. Since the model hitherto is identical to that of Betts and Devereux (2000), the first order conditions are the same as in their model.

  9. For instance, in Schmidt (2006): “[w]elfare effects were derived as the discounted sum of all future utility changes compared to the steady-state path of utility.”

  10. As typical in the literature, I neglect the utility derived from real balances.

  11. Because preferences are identical across regions and the law of one price holds for all goods, the CPI-based real exchange rate is always constant.

  12. In the Obstfeld and Rogoff (1995) model, the overall welfare effect of a monetary shock is \(\hat{U}_{Overall}=\hat{U}_{Overall}^{\ast }=\frac{\beta +\varepsilon (1-\beta )}{\theta }\left[ n\hat{M}+\left( 1-n\right) \hat{M} ^{\ast }\right] \). Using the same parameter values as in the present model, the previous equation implies that a monetary shock increases domestic and foreign utility by 0.083% in the Obstfeld and Rogoff (1995) model. This amounts to approximately half of the welfare gain of this model. Why? In the present model, the parameter value chosen for staggered pricing implies an average delay of four periods for pricing adjustment, while Obstfeld and Rogoff (1995) have prices that are sticky for one period. This implies a stronger liquidity effect of monetary policy in this model.

  13. Pierdzioch (unpublished manuscript) extends the model of Betts and Devereux (2000) by the introduction of the Calvo price-setting framework. He analyses the positive effects of monetary shocks in the presence of full LCP. Thus, the model of this paper, in the LCP case, replicates the results of Pierdzioch (unpublished manuscript). In addition, I also analyse the welfare effects of monetary shocks.

  14. Only the effects on output and consumption are shown. The setting of θ = 3 has virtually no impact on variables other than outputs, except for the fact that the welfare effects of the shock are different in the case of θ = 3. This is likely to be caused by the fact that this parameter also determines the initial level of output, implying that equilibrium output is far below the socially optimal level. Thus any increase in consumption is more likely to be welfare improving.

  15. The consequences of varying \(\upgamma \) for the other variables than European output are purely quantitative.

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Authors and Affiliations

  1. Department of Economics, University of Helsinki and HECER, P.O. Box 17, 00014, Helsinki, Finland

    Juha Tervala

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  1. Juha Tervala
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Correspondence to Juha Tervala.

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Financial support from the Yrjö Jahnsson Foundation is gratefully acknowledged. I am grateful to Vesa Kanniainen, Mika Kortelainen, Anne Mikkola, Tapio Palokangas, Jouko Vilmunen and seminar participants at the University of Helsinki and HECER for comments. In addition, I am especially grateful to the referees for their many useful comments.

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Tervala, J. The International Transmission of Monetary Policy in a Dollar Pricing Model. Open Econ Rev 21, 629–654 (2010). https://doi.org/10.1007/s11079-008-9105-5

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