Optimal monetary policy in an economy with vertical production and trade: An analysis based on the perspective of local currency pricing

By incorporating the factor of firms’ asymmetric price setting behavior into a two-country model with vertical production and trade, we analyze the issues of optimal monetary policies in non-cooperative and cooperative equilibriums. The three main results to be stressed are as follows. First, we show that if the home and foreign countries have identical ratios with respect to intermediate goods firms that set their export prices in the local currency, the optimal monetary stance in a non-cooperative equilibrium is eased in response to an increase in the ratios. Second, under such an optimal monetary stance, we show that welfare is maximized in both the home and foreign countries if all home and foreign intermediate goods firms set their export prices in the local currency. Third, in a scenario where not all home and foreign intermediate goods firms adopt this pricing strategy, we show that there is always a welfare gain from cooperation.