WELFARE AND MACROECONOMIC INTERDEPENDENCE [*].

We develop a baseline model of monetary and fiscal transmission in interdependent economies. The welfare effects of expansionary policies are related to monopolistic supply in production and monopoly power of a country in trade. An unanticipated exchange rate depreciation can be beggar-thyself rather than beggar-thy-neighbor, as gains in domestic output are offset by deteriorating terms of trade. Smaller and more open economies are more prone to suffer from inflationary shocks. Larger economies benefit from moderate demand-led expansions, but may he worse off if policy-makers attempt to close the output gap. Fiscal shocks are generally beggar-thy-neighbor in the long run; in the short run they raise domestic demand at given terms of trade, thus reducing the welfare benefits from monetary expansions. Analytical tractability makes our model uniquely suitable as a starting point to approach the recent "new open-economy macroeconomic" literature.

I. INTRODUCTION

How are policy shocks transmitted in open economies? How do they affect national residents' welfare? This paper is part of the ongoing research program aimed at building a modem theoretical paradigm for international policy evaluation--based on micro-founded models of imperfect competition with nominal rigidities--to address such questions. In the new literature, as in the traditional Mundell-Fleming-Dornbusch model, nominal shocks increase domestic output and employment and depreciate the real exchange rate. In contrast to the traditional approach, policy analysis based on the new models can rely on an index of social welfare that is logically consistent with the behavioral analysis of the international transmission mechanism.

The first generation of contributions to the new literature [1] has emphasized the welfare and policy implications of monopoly distortions in production, extending to an open-economy setting the key conclusions of influential closed-economy models such as Blanchard and Kiyotaki [1987] and Ball and Romer [1990]. [2] In such models wages and prices are suboptimally high, while output and consumption are suboptimally low. Given nominal rigidities, a small demand shock that raises output toward its efficient levels also improves national welfare. Consistently, in the benchmark open-economy model by Obstfeld and Rogoff [1995], a small unanticipated monetary expansion raises consumption and welfare everywhere in the world economy, no matter whether the shock originates at home or abroad. Only if one considers other internal inefficiencies in addition to monopolistic supply (such as nonlump-sum income taxes) do money shocks have asymmetric effects on domestic and foreign residents.

In open economies, however, there exists an economic distortion that is directly associated with openness, namely, a country's power to affect its terms of trade by influencing the supply of its products. The literature still lacks a comprehensive exploration of the interplay between internal and external sources of economic distortion (that is, monopolistic supply in production and monopoly power of a country in trade) that lies at the very core of the "new open-economy macroeconomics." This paper attempts to fill this gap by providing a baseline choice-theoretic analysis of monetary and fiscal transmission in interdependent economies.

When we account for both internal and external distortions, the analogies of policy analysis in open- and closed-economy models break down in several crucial dimensions. Consider, for instance, the effects of unanticipated money shocks. In both closed and open economies with nominal rigidities, monetary surprises raise output toward its efficient level. In open economies, however, they also reduce domestic consumers' purchasing power in the global markets. Because of the latter effect, expansionary policies can be beggar-thyself Smaller and more open economies are more likely to suffer from domestic nominal shocks that worsen their terms of trade. Larger economies, that could benefit from moderate output and employment gains, are actually worse off if policy-makers engineer large monetary expansions in an attempt to close the gap between actual and potential output.

Our analysis has rather unorthodox policy implications. In contrast with the popular model of competitive devaluations, exchange rate shocks are not beggar-thy-neighbor: due to deteriorating terms of trade, the benefits from a domestic monetary expansion accrue primarily to foreigners. Also in contrast with the conventional wisdom, domestic fiscal expansions hurt the trading partners: fiscal linkages are in general beggar-thy-neighbor in the long run. In the short run, fiscal shocks modify the trade-off between employment and domestic inflation by raising domestic demand at unchanged terms of trade, thus reducing the welfare benefits from a monetary expansion.