Production Interdependence and Welfare

By Kevin X.D. Huang and Zheng Liu
June 2004 
RWP 04-04
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      The international welfare effects of a country’s monetary policy shocks have been controversial in the literature. While a unilateral monetary expansion increases the production efficiency in each country, it affects terms of trade in favor of one country against another depending on the currencies of price setting. We show that the increased world production interdependence magnifies the efficiency-improvement effect while dampening the terms-of-trade effect. As a consequence, a unilateral monetary expansion can be mutually beneficial and thus Pareto improving regardless of in which currency unit prices are set. In this sense, international monetary policy transmission may not be a source of potential conflict in a world with production interdependence.

Keywords: Stages of processing; Monopolistic competition; Local currency pricing; Welfare

JEL Codes: E32, F31, F41

Kevin Huang is a senior economist at the Federal Reserve Bank of Kansas City. Zheng Liu is an assistant professor in the Department of Economics at Emory University. The authors are grateful to the audience at the 2002 Econometric Society Summer Meeting, the 2002 Society for Economic Dynamics Annual Meeting, the 2002 European Economic Association Annual Congress, the 2002 Federal Reserve System Committee Meeting on International Economics, and seminar participants at George Washington University and the Federal Reserve Bank of Kansas City for helpful comments. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Huang email:  kevin.huang@kc.frb.org
Liu email:  zliu5@emory.edu

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