Monetary policy in open economies with production networks
What this paper finds — and why it matters
This paper studies the design of monetary policy in a multi-sector small open economy with domestic input-output linkages and cross-border production networks, under nominal price rigidities in domestic sectors. The main result is that the monetary policy that closes the domestic output gap is nearly optimal, and it is implemented by stabilizing an aggregate inflation index that weights each sector’s inflation by its role as a supplier of inputs and a net exporter within the international production network. Sectors with small direct or indirect import shares receive large weight in the index; ignoring cross-border linkages leads monetary policy to overemphasize inflation in sectors that are intensive exporters directly or indirectly through downstream sectors. Three channels link sectoral markup wedges to the aggregate output gap: the CPI channel (present in closed economies too) and the net export income and net profit income channels (unique to open economies with cross-border linkages). Using the World Input-Output Database, the output-gap-closing policy is shown to outperform alternatives that abstract from economic openness or input-output linkages.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What is the output gap monetary policy and how is it implemented?
The output gap (OG) monetary policy stabilizes the aggregate inflation index proportional to the aggregate output gap—defined as the difference between output in the sticky-price equilibrium and in the efficient flexible-price equilibrium—by weighting each sector’s inflation according to the product of its price rigidity and its OG weight. The price rigidity component maps positive sectoral inflation into a negative sectoral markup wedge under nominal rigidities; the OG weight measures the sector’s contribution to the aggregate output gap through domestic and cross-border network linkages. This policy eliminates first-order aggregate distortions and is shown to be nearly optimal.
Q2. What are the CPI, net export income, and net profit income channels?
Three channels link a negative sectoral markup wedge to a positive aggregate output gap: the CPI channel (lower domestic prices raise real factor prices and stimulate supply), the net export income channel (lower domestic prices increase net exports and domestic labor income), and the net profit income channel (two opposing effects: lower prices increase net export profits but also raise the cost of imported inputs). The CPI channel operates in closed economies as well, while the net export income and net profit income channels are unique to open economies with cross-border input-output linkages.
Q3. Why does ignoring cross-border linkages lead monetary policy to overweight intensive exporters?
Failing to account for cross-border production networks causes monetary policy to overemphasize inflation in sectors that export intensively directly and indirectly—because the net profit income channel, which reduces the OG contribution of intensive exporters by raising the cost of their imported inputs, is omitted when the economy is treated as closed. Without the cross-border linkages, intensive direct or indirect exporting sectors appear to have larger aggregate output gap contributions through domestic channels alone, causing the aggregate inflation index to over-weight those sectors.
Q4. How do the results relate to existing monetary policy frameworks?
The paper bridges the multi-sector closed-economy result that optimal policy targets a Domar-weighted aggregate inflation index and the one-sector open-economy result that optimal policy trades off domestic inflation against terms-of-trade distortions, showing that cross-border input-output linkages modify the Domar weights through the net export income and net profit income channels. In the limit where all sectors have no cross-border linkages, the OG weights reduce to Domar weights; the one-sector open economy policy prescription is a special case of the general framework.
Q5. What is the empirical validation?
Using the World Input-Output Database, the paper computes the theoretical sectoral OG weights for actual economies and shows that the OG monetary policy outperforms alternative policies that ignore either economic openness or input-output linkages. The database provides cross-country cross-sector data on intermediate input flows that allow computation of the model’s OG weight formulas for real economies.
Key concepts
output gap (OG) monetary policy : the monetary policy that closes the aggregate output gap (difference between sticky-price and efficient flexible-price output), implemented by stabilizing the network-weighted aggregate inflation index; shown to be nearly optimal in the open-economy production network framework.
sectoral OG weight : the weight assigned to a sector’s inflation in the aggregate inflation index under OG monetary policy; measures the sector’s contribution to the aggregate output gap through the CPI, net export income, and net profit income channels; differs from the Domar weight in open economies due to cross-border linkages.
Domar weight : the ratio of a sector’s gross output to GDP; the weight used in the closed-economy multi-sector optimal inflation index literature; coincides with the OG weight when there are no cross-border production linkages.
labor wedge : a weighted average of sectoral markup wedges proportional to the aggregate output gap; the monetary policy target in the OG framework.
efficiency wedge : a weighted average of exogenous sectoral shocks; determines the efficient flexible-price equilibrium; independent of sectoral markup wedges at first order, so the OG policy can separately close the aggregate distortions caused by markup wedges.