Optimal Monetary Policy with Vertical Production and Trade *

Kang Shi () and Juanyi Xu ()

Review of International Economics, 2007, vol. 15, issue 3, pages 514-537

Abstract: This paper explores the optimal monetary policy response to domestic and foreign technology shocks in an open economy with vertical structure of production and trade. We find that any stage-specific productivity shock in one country may have a transborder spillover effect on the other country via the vertical trade. So when choosing optimal monetary rules, each monetary authority should respond to both home and foreign productivity shocks. Also, the flexible exchange rate cannot replicate the flexible price equilibrium, even under producer currency pricing, due to price stickiness in multiple stages. We also find that the existence of a transborder spillover effect depends on the currencies of price setting. Finally, vertical trade may affect the value of exchange rate flexibility under PCP and LCP setting. Copyright © 2007 The Authors; Journal compilation © 2007 Blackwell Publishing Ltd.

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