Trade, Unemployment, and Monetary Policy

We study the effects of trade integration for the conduct of monetary policy in a two-country model with heterogeneous firms, endogenous producer entry, and labor market frictions. The model reproduces important empirical regularities related to international trade, namely synchronization of business cycles across trading partners and reallocation of market shares across producers. Three key results emerge. First, when trade linkages are weak, the optimal policy is inward-looking and requires significant departures from price stability both in the long run and over the business cycle. Second, as trade integration reallocates market share toward more productive firms, the need of positive inflation to correct long-run distortions is reduced. Third, increased business cycle synchronization implies that country-specific shocks have more global consequences. The constrained efficient allocation generated by optimal cooperative policy can still be achieved by appropriately designed inward-looking policy rules. However, sub-optimal policy implies inefficient fluctuations in cross-country demands that result in large welfare costs and increased gains from cooperation when trade linkages are strong. JEL Codes: E24; E32; F16; E52, F41, J64.