Three essays on openness, international pricing, and optimal monetary policy

The unifying theme of this dissertation is to ask questions about how pricing inefficiencies and institutional characteristics interact to influence the aggregate real outcomes of countries in an open economy setting in which each country’s monetary policy is set optimally. Chapter 1 tries to answer the question of whether openness is inflationary using a two-country general equilibrium model with optimal monetary policy that is explicitly derived from microeconomic foundations. Imperfect competition plays a key role and is modeled as a degree of inelasticity of substitution among differentiated goods. I find that a country’s inflation rate increases with its degree of openness and that this inflationary effect is dampened by the degree of imperfect competition. In Chapter 2, I ask the same question of whether openness is inflationary, but I change the imperfect competition structure from Chapter 1 so that workers supply differentiated labor to a competitive final goods producer. This more closely follows the theoretical story cited by much of the empirical literature on openness and inflation. However, the interesting result in Chapter 2 is that the implications for optimal monetary policy and real outcomes are the same as in Chapter 1. That is, the source of the imperfect competition does not matter. Chapter 2 then goes on to evaluate much of the empirical literature on the basis of whether it controls for imperfect competition among goods producers and among suppliers of labor. Finally Chapter 2 includes an empirical test of the theory. Using a sample from 1987 to 2002, the data confirm the implication of my model that increased openness can be inflationary—a result that contradicts much of the previous empirical literature Lastly, Chapter 3 deals with the question of how a monetary authority should respond to foreign monetary policy. The model relaxes the assumption of rational expectations in order to generate steady state equilibria that are neither overly inflationary nor independent of foreign monetary policy. The resulting monetary policy rules are well below the upper bound of money growth and are an increasing function of the history of foreign monetary policy.