Journal Issue
Share
Article

Dynamic Aspects of Productivity Spillovers, Terms of Trade and The “Home Market Effect”

Author(s):
International Monetary Fund. Research Dept.
Published Date:
November 2009
Share
  • ShareShare
Show Summary Details

Recent empirical researches, such as Corsetti, Dedola, and Leduc (2006); Corsetti, Martin, and Pesenti (2007) (henceforth CMP); Debaere and Lee (2003); Hummels and Klenow (2005); and Kang (2005), conclude that the terms of trade improve even after the positive productivity shock hits the economy among advanced economies. This is quite contrary to the conventional wisdom because the home technological progress usually results in lower domestic prices. An increased supply of goods from an economy with high productivity growth should be absorbed by the rest of the world at falling prices, which should result in a deterioration of the terms of trade. This is what is concluded in the seminal research by Armington (1969).

CMP analytically show that a static two-country model with endogenous firm entry1 can generate improvement of the terms of trade in response to a positive technology shock in the form of lowering the entry cost.2 As there is no direct changes in the real marginal cost stemming from the lowered entry cost, prices set by individual firms do not change very much. Under such circumstances, the terms of trade correspond one to one with nominal exchange rates. Increase in the number of firms reflecting the lower entry cost results in tighter demand conditions for domestic labor and consequently appreciates nominal exchange rates through the relative increase in domestic wages.3 “Hence, the Home terms of trade strengthen as the array of Home products increases” (CMP, p. 114). On the other hand, however, the welfare-based price index becomes smaller in the domestic country than in the rest of the world as the array of home products increases more. Reflecting these developments in prices, the real exchange rate, the nominal exchange rate denominated by the welfare-based price indices, namely, the international relative price in the extensive margin, depreciates for the domestic country. CMP further demonstrate directions of theoretical responses of international relative prices to the shocks that expand the production frontier, namely an increase in productivity and in labor population in addition to the efficiency gains in creating new firms. CMP show that an increase in labor population works like the efficiency gains, because it increases the number of firms as long as there is a trade cost that induces the home market effect.

This paper evaluates the robustness of the results in CMP in a model with richer and more realistic dynamics such as one period lag in firm dynamics and nominal price as well as wage stickiness.4 We first set up a model that incorporates firm dynamics into the Global Economy Model (GEM). Then, we demonstrate how the economic variables respond to the shocks that shift the production frontier outwards, namely productivity gains in manufacturing, and efficiency gains in creating new firms. Our main conclusions are that short-run responses could be different from those in CMP because of the existence of real as well as nominal rigidities; and that persistence of shocks also alters the direction of responses via the wealth effect. These results suggest that it is of great importance for policy institutions to acknowledge the dynamic aspects of productivity spillovers by simulating a model with richer dynamics like the GEM.

The next section of this paper briefly introduces our model. Section II analyzes the international implication of shocks, which expand the production frontier outwards, on international relative prices. We examine two shocks, namely, productivity gains in manufacturing and efficiency gains in creating new firms. We show how responses could be different in a model with richer and more realistic dynamics than those obtained analytically in a static model in CMP. Section III shows such responses in a two-country model calibrated for the Japan and the rest of the world following Laxton, N’Diaye, and Pesenti (2006).

I. The Model

The model used in this paper is based on the recent literature, which combines the “New Trade Theory” advocated by Krugman (1980). Because the heterogeneous technology level among firms is not considered in this paper, our model can be interpreted as a dynamic extension of CMP or a two-country extension of Bilbiie, Ghironi, and Melitz (2005, 2006, 2007) and Bergin and Corsetti (2005). Contrary to these previous studies, our model includes richer and more realistic dynamics, such as nominal price and wage rigidities. Because our model is based on the GEM, it has richer dynamics and can reproduce the regularities in the observed data.

The production structure of this model is summarized in Figure 1. Intermediate goods (Y) are produced using only labor (L), which is also used for creating new firms (F). Then, they are used as intermediate inputs in final goods (Q) production5 in either the domestic or the foreign country as imported intermediate inputs (M). All final goods produced this way (C) are consumed. The details are shown in Fujiwara and Hirakata (2007).

Figure 1.Production Structure

II. International Implications of Expanding the Production Frontier

This section examines whether the directions of responses analytically derived by CMP remain valid in a model with richer and more realistic dynamics like ours. We examine two shocks, namely (1) productivity gains in manufacturing, and (2) efficiency gains in creating new firms. In each shock simulation, we first introduce the intuitive explanation of responses described in CMP. Then, we show and explain the impulse responses in our model.

There exist several differences between simulations in this paper and those examined in CMP. First, as has been mentioned, the model is different. Our model contains much richer and more realistic dynamics such as one period lag for new firms to start operating, and nominal price and wage rigidities. Markups fluctuate in our model. Second, the model considered in CMP does not have any intrinsic dynamics. Hence, the direction of responses obtained in CMP is considered to be that of the steady-state (long-run) responses rather than the (short-run) dynamic responses, which reflect richer dynamics.

Regarding the first point, we will also show the simulation results of the flexible price counterpart.6 Although there is no nominal rigidity in this model, the welfare-based price level still fluctuates as the number of firms existing in the economy changes. Regarding the second point, the short-run as well as the long-run—namely the steady-state—effects of these shocks will also be demonstrated in each model simulation. The long-run simulation results simply show the steady-state changes in the endogenous variables for shifts in productivity and entry cost.

The variables of interest are, as in CMP, the number of firms, the home terms of trade,7 and the real exchange rate, because we focus our attention on the international spillovers of production-enhancing technology via international relative prices. The terms of trade are on a firm basis. Therefore, it is the international relative price in the intensive margin. On the other hand, the real exchange rate is denominated by the welfare-based CPI index, which considers the taste for variety. Hence, this is considered to be the international relative price in the extensive margin. Because the terms of trade in this paper are defined as the ratio of import prices over export prices, the positive reaction means worsening of terms of trade. Similarly, the real exchange rate is defined in a standard manner where it is appreciating when it becomes smaller. In this paper, the numeraire is assumed to be the welfare-based CPI index but it is the nominal wage in CMP.

Productivity Gains in Manufacturing

According to CMP, from a microeconomic perspective, an increase in technology results in lower marginal costs. Therefore, each firm intends to lower its price so as to expand its sales share in the market. On the other hand, from a macroeconomic perspective, this intensified competition among firms lowers the profits of each firm because of the reduced price. If the wealth effect stemming from productivity gains in manufacturing on leisure is strong, increases in consumption demand become mild. As a result, profits are not sufficient to cover the entry cost, and some firms exit from the market. If such wealth effects are not very strong, several new firms consider it profitable to enter the market because the expected profit stream is large enough to cover the entry cost. As for the effects on the terms of trade, reflecting the lower price charged by the domestic firms, the terms of trade worsen in the domestic country reflecting the productivity gains. The domestic price level becomes lower because of the reduced marginal cost as well as the increased number of varieties, causing the welfare-based price level to decrease. Reflecting these developments in prices both in intensive and extensive margins, the real exchange rate depreciates. According to CMP, directions of responses of the foreign variables, namely the number of firms and the welfare-based price level, are ambiguous.

Figure 2 shows the dynamic responses for the productivity gains in manufacturing. The directions of responses are consistent with those obtained in CMP. In our model simulation, the increased technology in manufacturing causes profits to increase high enough for new firms to start business. As explained in CMP, the terms of trade deteriorate because the lowered marginal cost reduces the price of each domestic good. Because the size of the changes in the number of firms in domestic and foreign countries is similar, the real exchange rate depreciates reflecting the international relative prices in the intensive margin. The responses in a flexible price model are demonstrated in Figure 3. Because of the existence of one period lag for new firms to start operating, the number of firms increases only gradually as observed in the sticky price model. The directions of responses are consistent with those predicted in CMP. It now becomes more evident that because of the lowered marginal cost, the real exchange rate significantly depreciates for the domestic country. Figures 2 and 3 also show that increase in the number of firms is more dramatic in the sticky price model than in the flexible price model. This reflects more profit opportunities stemming from higher markups thanks to nominal rigidities.

Figure 2.Sticky Price Model for Productivity Gains

Note: ROW = rest of world. Vertical axis is percentage deviation from steady state. Horizontal axis is period.

Figure 3.Flexible Price Model for Productivity Gains

Note: ROW = rest of world. Vertical axis is percentage deviation from steady state. Horizontal axis is period.

We also checked the long-run directions of the responses for the productivity gain, namely, the changes in the steady state after the increase in technology, which are shown in Table 1. They turn out to be the same as those of the dynamic responses.8

Table 1.Summary Table for Productivity Gains
CMPGEM Base
Short-runLong-run
StickyFlexible
n?+++
n*?+++
TOT++++
RER++++
Note: + = worsening of the terms of trade and depreciation of the real exchange rate. CMP = Corsetti, Martin, and Pesenti (2007); GEM = Global Economy Model; TOT = terms of trade; RER = real exchange rate.
Note: + = worsening of the terms of trade and depreciation of the real exchange rate. CMP = Corsetti, Martin, and Pesenti (2007); GEM = Global Economy Model; TOT = terms of trade; RER = real exchange rate.

Table 1 summarizes the directions of responses in both CMP and our model. We can conclude that concerning the productivity gain, the results obtained in CMP hold in a model with much richer dynamics than the GEM.

Efficiency Gains in Creating New Firms (Goods)

Now, we will check the results obtained in CMP for the efficiency gain in creating new firms. CMP conclude that the lower fixed cost to entry naturally increases the number of the varieties in the domestic economy. As there is no direct changes in the real marginal cost stemming from the lowered entry cost, prices set by individual firms do not change very much. Under such circumstances, the terms of trade correspond one to one with nominal exchange rates. Increase in the number of firms reflecting the lower entry cost results in tighter demand conditions for domestic labor and consequently appreciates nominal exchange rates through the relative increase in domestic wages. “Hence, the Home terms of trade strengthen as the array of Home products increases” (CMP, p. 114). On the other hand, however, as the number of firms increases more in the domestic country, the welfare-based price index becomes smaller in the domestic country than in the rest of the world as the array of home products increases more. Reflecting these developments in prices, the real exchange rate, the nominal exchange rate denominated by the welfare-based price indices, namely, the international relative price in the extensive margin, depreciates for the domestic country.

Figure 4 shows the responses in the sticky price model. All responses are almost consistent with the prediction by CMP. The number of firms increases, the terms of trade improve, but the real exchange rate depreciates because the welfare-based consumer price index (CPI) becomes smaller in the domestic country than in the foreign country, reflecting the dynamics of the number of varieties. The direction of the response of the terms of trade is not significant. It tends to fluctuate rather than improving as predicted by CMP. This reflects the fluctuations in the markup because of nominal rigidities.9 As shown in Figure 5, the response of the terms of trade is exactly what is expected by CMP without such nominal rigidities. The fact that the real exchange rate initially appreciates in the flexible price model is somewhat puzzling. This implies that the appreciation in nominal exchange rates and the improvement of the terms of trade are very strong in this economy. Nominal exchange rates are appreciating thanks to the strong demand conditions in the domestic country. At the same time, a reduction in the entry cost induces investment for creating new firms, but, because of the existence of one period lag in firm dynamics, an immediate increase in the number of firms is prevented.10 Therefore, adjustments through the extensive margin for the depreciation of the real exchange rate are hindered. As a result, the channel to increase the demand for investing in new firms becomes more significant soon after the shock hits the economy. According to this channel, a reduction in the entry fixed cost, as if it were a standard demand shock, raises the price set by each domestic firm and therefore further improves the terms of trade in the early stage of responses.11

Figure 4.Sticky Price Model for Efficiency Gains

Note: ROW = rest of world. Vertical axis is percentage deviation from steady state. Horizontal axis is period.

Figure 5.Flexible Price Model for Efficiency Gains

Note: ROW = rest of world. Vertical axis is percentage deviation from steady state. Horizontal axis is period.

As for the long-run responses, Table 2 demonstrates that they are consistent with the prediction in CMP. However, responses of some variables in the long run differ from those in the short run because the wealth effect becomes more prevalent with the permanent shock.

Table 2.Summary Table for Efficiency Gains
CMPGEM Base
Short-runLong-run
StickyFlexible
n++++
n*?++
TOT− to +
RER++− to ++
Note: + = worsening of the terms of trade and depreciation of the real exchange rate. CMP = Corsetti, Martin, and Pesenti (2007); GEM = Global Economy Model; TOT = terms of trade; RER = real exchange rate.
Note: + = worsening of the terms of trade and depreciation of the real exchange rate. CMP = Corsetti, Martin, and Pesenti (2007); GEM = Global Economy Model; TOT = terms of trade; RER = real exchange rate.

Directions of both short-run and long-run responses are summarized in Table 2. The differences in directions between short-run and long-run responses and between our model and CMP suggest the importance of the degree of the wealth effects, and the dynamics embedded in our model such as one period lag in firm dynamics and the nominal rigidities.

This means that for a proper conduct of monetary policy, we need to check simulations not only from the theoretical model but also from a model with richer dynamics like the GEM.

III. Two-Country Example: Japan and the Rest of the World

In order to understand the realistic size of the international spillovers with more empirical relevance than in the previous analyses as above, this section first recalibrates our two-country model so that we can depict the relationship between Japan and the rest of the world. All parameters except for firm dynamics are taken from Laxton, N’Diaye, and Pesenti (2006).12

We will again show the responses for productivity gains in manufacturing and efficiency gains in creating new firms. All shocks occur in Japan not in the rest of the world.13

Figure 6 demonstrates the dynamic responses for the productivity gains in manufacturing when we give one percentage level shock to technology. As the theory or CMP predicts, qualitatively similar responses to those in Figure 2 are obtained. The increased technology in manufacturing causes profits to increase high enough for new firms to start business. The terms of trade deteriorate because the lowered marginal cost reduces the price of each domestic good. Because the welfare-based price level in the domestic country is also decreased mainly due to the reduced marginal cost, the real exchange rate also depreciates. For a 1 percentage point level shock to technology, terms of trade deteriorates by about 1 percent and the real exchange rate also depreciates by the same amount at their peaks. Because of the assumption about the country size, the responses in the rest of the world are not very large. Yet, the directions of the responses are the same both in Figures 2 and 6.

Figure 6.Responses for Productivity Gains

Note: ROW = rest of world. Vertical axis is percentage deviation from steady state. Horizontal axis is period.

Figure 7 shows the responses for the efficiency gains in creating new firms. For a reduction in the fixed entry cost of 1 percentage point in creating new firms in Japan, the number of firms increases. This seems to result in the smaller welfare-based CPI in the domestic country than in the foreign country. These movements are mostly consistent with the theory that is explained in CMP. However, the direction of the terms of trade is ambiguous and the real exchange rate initially appreciates, in the model with more empirical relevance examined in this section. The terms-of-trade responses mostly reflect markup fluctuations. This again implies the importance of the nominal rigidities to understand the realistic responses of the international relative prices to shock. Owing to the nominal rigidities, namely the increase in the markup in this case, the number of firms increases massively in the domestic country reflecting more profit opportunities.

Figure 7.Responses for Efficiency Gains

Note: ROW = rest of world. Vertical axis is percentage deviation from steady state. Horizontal axis is period.

On the other hand, the reason for the appreciation of the real exchange rate is as follows. Although Japan is a small county compared with the rest of the world, the elasticity of substitution between domestic and foreign goods necessitates the increase in imports and therefore import-goods inflation reflecting tighter demand conditions, which also result in the ambiguous movements in the terms of trade.14 Consequently, the real exchange rate denominated by the welfare-based CPI appreciates despite the increase in the number of firms in Japan. Overall, experiments with a model calibrated for the relationship between Japan and the rest of the world again show the importance of nominal rigidities, and the persistence of shocks on the directions of responses of the international relative prices.

IV. Conclusion

This paper has shown how international relative prices respond to shocks that shift the production frontier outwards, namely, productivity gains in manufacturing and efficiency gains in creating new firms in a two-country model. For this purpose, contrary to the theoretical model used in CMP, we set up a model that contains richer and more realistic dynamics embedded in the GEM such as nominal price and wage stickiness. Our main conclusions are that real as well as nominal rigidities also alter the short-run responses by changing the responses of the number of firms and markups; and that persistence in shocks also matters for the determination of the direction of responses because it changes the size of the wealth effect. The nominal rigidities have significant effects on the price setting and therefore the markup determination, but the magnitude of the wealth effects is dependent on the persistence of the shocks. As a result, these factors are naturally considered to be very important determinants of the impulse responses. These results suggest that for a proper conduct of monetary policy, we need to check simulations not only from a theoretical model but also from a model with richer and more realistic dynamics like the GEM.

References

    ArmingtonP.1969A Theory of Demand for Products Distinguished by Place and ProductionIMF Staff Papers Vol. 16 No. 1 pp. 15978.

    BenignoG. and C.Thoenissen2003Equilibrium Exchange Rates and Supply-Side PerformanceEconomic Journal Vol. 113 No. 486 pp. 10324.

    BerginP.R. and G.Corsetti2005Towards a Theory of Firm Entry and Stabilization PolicyNBER Working Paper 11821 (Cambridge, MassachusettsNational Bureau of Economic Research).

    BilbiieF.F.Ghironi and M.J.Melitzeditors2005“Business Cycles and Firm Dynamics” (unpublished; Nuffield College, University of Oxford).

    BilbiieF.F.Ghironi and M.J.Melitz2006“Monopoly Power and Endogenous Variety in Dynamic Stochastic General Equilibrium: Distortions and Remedies” (unpublished; Nuffield College, University of Oxford).

    BilbiieF.F.Ghironi and M.J.Melitz2007“Monetary Policy and Business Cycles with Endogenous Entry and Product Variety” in NBER Macroeconomics Annual 2007 (CambridgeMassachusetts, National Bureau of Economic Research).

    CorsettiG.L.Dedola and S.Leduc2006Productivity, External Balance and Exchange Rates: Evidence on the Transmission Mechanism among G7 CountriesNBER Working Paper No. 12483 (CambridgeMassachusetts, National Bureau of Economic Research).

    CorsettiG.P.Martin and P.Pesenti2007Productivity, Terms of Trade and the ‘Home Market Effect’Journal of International Economics Vol. 73 No. 1 pp. 99127.

    DebaereP. and H.Lee2003“The Real-Side Determinants of Countries’ Terms of Trade” (unpublished; University of Texas, Austin).

    FujiwaraI.2007Re-Thinking Price Stability in an Economy with Endogenous Entry: Real Imperfections and Product Variety” (unpublished; Institute for Monetary and Economic Studies, Bank of Japan).

    FujiwaraI. and N.Hirakata2007Dynamic Aspects of Productivity Spillovers, Terms of Trade and The ‘Home Market Effects’IMES Discussion Paper 07-E-07 (Institute for Monetary and Economic StudiesBank of Japan).

    FujiwaraI. and N.Hirakata2008A Note on ‘Productivity Spillovers, Terms of Trade and the Home Market Effects’” (unpublished; Institute for Monetary and Economic StudiesBank of Japan).

    GhironiF. and M.J.Melitz2005International Trade and Macroeconomic Dynamics with Heterogeneous FirmsThe Quarterly Journal of Economics Vol. 120 No. 3 pp. 86515.

    HummelsD. and P.J.Klenow2005The Variety and Quality of a Nation’s ExportsAmerican Economic Review Vol. 95 No. 3 pp. 70423.

    KangK.2005“The Path of Export Variety and Terms of Trade”PhD dissertationUniversity of CaliforniaDavis.

    KrugmanP.1980Scale Economies, Product Differentiation, and the Pattern of TradeAmerican Economic Review Vol. 70 No. 5 pp. 95059.

    LaxtonD.P.N’Diaye and P.Pesenti2006Deflationary Shocks and Monetary Rules: An Open-Economy Scenario AnalysisJournal of the Japanese and InternationalEconomies Vol. 20 No. 4 pp. 66598.

    MelitzM.J.2003The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry ProductivityEconometrica Vol. 71 No. 6 pp. 1695725.

IMF Staff Papers

www.palgrave-journals.com/imfsp/

IMF Staff Papers is published by Palgrave Macmillan, on behalf of the International Monetary Fund (IMF).

Publisher All business correspondence and enquiries should be addressed to IMF Staff Papers, The Journals Publisher, Palgrave Macmillan, Brunel Road, Houndmills, Basingstoke, Hampshire RG21 6XS, UK. Tel: + 44 (0)1256 329242. Fax: +44 (0)1256 320109

Palgrave Macmillan is an imprint of Macmillan Publishers Limited, registered in England, company number 785998. Registered office as above. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries.

IMF Staff Papers is online at www.palgrave-journals.com/imfsp. Visit the journal’s home pages for details of aims and scope, readership, instructions to authors and how to contact the Editors and publishing staff. Use the website to order a subscription, reprints, a sample copy or individual articles and search online tables of contents and our abstracts service.

Free to all readers: tables of contents and abstracts of articles. Register to receive the table of contents by e-mail as each issue is published.

2010 Site License and Subscription Rates

New Institutional policy

Palgrave has moved to a site license policy for institutional online access using prices based on non-science Full Time Equivalents. These are sold by our sister company, Nature Publishing Group.

Separate print only institutional subscriptions are also available. Please see www.palgrave-journals.com/pal/subscribe for full details.

Institutional site licenses

Contact your local sales representative for a tailored price quote for your institution. You will be required to complete a NPG site license agreement.

E-mail: North America: institutions@natureny.com

  • Latin America: lasales@natureny.com

  • Asia Pacific: institutions@natureasia.com

  • Australia and New Zealand: nature@macmillan.com.au

  • India: npgindia@nature.com

  • UK and rest of world: institutions@nature.com

More information is available at www.nature.com/libraries

Institutional print subscriptions

EU: £104/RoW: £104/US$187

Individuals

Standard (online and print): EU: £58/RoW: £58/US$94

Online only: EU: £58/RoW: £58/US$94

Subscriptions—outside the USA

Orders must be accompanied by remittance. Cheques should be made payable to Palgrave and sent to: Palgrave Macmillan Subscriptions Department, Brunel Road, Houndmills, Basingstoke, Hampshire RG21 6XS, UK. Where appropriate, subscribers can make payment to UK Post Office Giro Account No: 519 2455. Full details must accompany the payment.

Subscriptions—USA

USA subscribers can call toll-free on: 1 866 839 0194. Please send cheque/money order/credit card details to: Palgrave Macmillan Journals Subscriptions, 175 Fifth Avenue, New York, NY, 10010, USA.

Prices are set in UK Sterling and US Dollars. All prices, subscriptions and details are subject to change without prior notification. Please note: print only subscriptions are available which are entered into at our standard subscription rates.

IMF Staff Papers (ISSN 1020-7635) is published four times a year by Palgrave Macmillan Ltd., c/o Mercury Airfreight International, 365 Blair Road, Avenel, NJ 07001, USA. Periodicals postage is paid at Rahway NJ, Postmaster: send address corrections to IMF Staff Papers, Palgrave Macmillan, c/o Mercury Airfreight International, 365 Blair Road, Avenel, NJ 07001, USA.

Advertising Enquiries concerning advertisements should be addressed to: advertising@palgrave.com. Our media pack can be viewed at www.palgrave-journals.com/pal/advertisers/index.html.

Reprints For reprints of any article in this journal please contact the publisher at the address above, or at reprints@palgrave.com.

Permissions For queries relating to reproduction rights please contact the rights office (rights@palgrave.com)

Copyright © 2009 International Monetary Fund

  • (IMF)

  • Print ISSN 1020-7635

  • Online ISSN 1564-5150

All rights of reproduction are reserved in respect of all papers, articles, illustrations, etc., published in this journal in all countries of the world. All material published in this journal is protected by copyright, which covers exclusive rights to reproduce and distribute the material. No material published in this journal may be reproduced or stored on microfilm or in electronic, optical or magnetic form without the written authorization of the publisher.

Authorization to photocopy items for internal or personal use of specific clients is granted by Palgrave Macmillan for libraries and other users registered with the Copyright Licensing Agency Ltd (CLA), Saffron House, 6-10 Kirby Street, London EC1N 8TS, UK, and the Copyright Clearance Centre (CCC) Transaction Reporting Service, 222 Rosewood Drive, Danvers, MA 01923, USA, provided that the relevant copyright fee is paid directly to the CLA or to the CCC at the above addresses. Identification code for IMF Staff Papers: 1020-7635/09.

Apart from any fair dealing for the purposes of research for a non-commercial purpose, or private study, or criticism or review, as permitted under the Copyright, Design and Patent Act 1988, this publication may be reproduced, stored or transmitted, in any form or by any means, only with the prior permission in writing of the publishers, or in the case of reprographic reproduction, in accordance with the terms of licences issued by the CLA or the CCC as described above.

This publication is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin.

Typeset by MPS Limited. A Macmillan Company, Bangalore, India Printed and bound by The Sheridan Press, Pennsylvania, USA

Ippei Fujiwara is a director with the Bank of Japan. Naohisa Hirakata is a deputy director with the Bank of Japan. The authors thank two anonymous referees, the editor, Kosuke Aoki, Menzie Chinn, Behzad Diba, Naoko Hara, Ryo Jinnai, Doug Laxton, Dirk Muir, and Paolo Pesenti for invaluable inputs. The paper benefited from discussions with participants at the BOC Workshop on Commodity Price Issues, the Bank of Japan seminar, and the IMF Workshop on Open Economy Models for Policy Evaluation.

Reflecting the growing interests in understanding the role of firm heterogeneity or endogenous variety in the international trade as the seminal research by Melitz (2003) represents, macroeconomists also start considering the consequences of incorporating the firm dynamics in dynamic stochastic general equilibrium models. See, for example, Bergin and Corsetti (2005); Bilbiie, Ghironi, and Melitz (2005, 2006, 2007); Fujiwara (2007); and Ghironi and Melitz (2005).

CMP (p. 104) set the nominal wage as a numeraire: “the exchange rate is defined as the relative price of Foreign labor in terms of Home labor units.” According to the first-order condition concerning the labor supply, namely that the marginal rate of substitution equals to the real wage, the nominal wage definitely increases as the number of firms increases. Therefore, the exchange rate appreciates and the terms of trade improve in response to the efficiency gains.

For the details of the model and simulations, please see Fujiwara and Hirakata (2007, 2008). The 2007 paper shows all the details of the model and simulation, and investigates some features not shown in this paper such as the importance of the elasticity of substitution between domestic and foreign goods for the direction of responses in international relative prices. Fujiwara and Hirakata (2008) focus exclusively on this elasticity issue in the same framework as employed in CMP.

As shown in Bilbiie, Ghironi, and Melitz (2005), regarding empirical problems associated with increasing returns to specialization and a constant elasticity of substitution production function, it may be better to model the household consuming a basket of goods defined over a continuum of goods. Neither specification, however, makes a difference in simulations conducted in this paper.

We set the Rotemberg-type adjustment cost for nominal price and wage rigidities to zero.

Note that the law of one price does not hold under the local currency pricing, the trade cost and sticky prices. In this paper we only show the terms of trade of the home country.

Because nominal rigidities have no influence on the steady state, the long-run responses in this flexible price model are the same as the baseline model. Therefore, we will not mention the long-run responses in the flexible price model henceforth.

As will be shown below, the elasticity of substitution between home and foreign products also affects the direction of the terms of trade.

In particular, in the period when the shock hits the economy, the number of firms cannot increase.

This implies that the one period lag in firm dynamics may also affect the dynamic responses for expanding the production frontier.

For details, see our accompanying paper Fujiwara and Hirakata (2007).

Responses for the shocks in the rest of the world are almost the mirror image of those for the shocks in Japan.

We assume the local currency pricing in this model. Therefore, tighter demand conditions in the domestic country do not directly feed into the price setting in the foreign country.

Other Resources Citing This Publication