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I am particularly indebted to Eswar Prasad, but would also like to thank Peter Christoffesen, Giovanni dell’Ariccia, Ilan Goldfajn, Hamid Faruqee, Lorenzo Giorgianni, and participants in the Fifth meeting (Graduate Institute of International Studies, Geneva, June ‘97) of the European Science Fundation-funded Research Group on “European Economic Integration” for helpful discussion. I am grateful to Jeffery Gable, Susana Mursula, and Mirko Novakovic for patient help with data collection. The ideas presented in the paper reflect those of the author and not necessarily those of the IMF.
This term is used to define a situation where some countries would participate immediately in EMU and other countries would join later.
Since Krugman (1991) emphasized the agglomeration effects deriving from trade costs and partial factor mobility in the usual new trade theory setup (monopolistic competition, increasing returns to scale and product differentiation) numerous other contributions have investigated related aspects: intermediate inputs (Krugman and Venables, 1996; Venables, 1996), congestion (from land rent, as in Elizondo and Krugman, 1992; from fixed local supply of housing, as in Helpman, 1996); trade policy (Elizondo and Krugman, 1992); taxation and spending (Trionfetti, 1997); debt policy (Trionfetti 1996); growth (Martin and Ottaviano, 1996); and different infrastructures across locations (Martin and Rogers, 1995).
There are several reasons why firms dislike variability of sales or why such variability affects expected profits negatively. Decreasing returns to scale in the presence of price rigidities generate a profit function which is concave in output (as in Ricci, 1997a). Costs of firing workers, of entering into a bankruptcy process, or of maintaining a stock, induce firms to dislike variability of sales. Other reasons are given by risk-averse owners facing incomplete financial markets, or risk-averse managers facing imperfect labor markets or enjoying nonmarketable payoffs (such as reputation, satisfaction).
In order to neutralize the usual agglomeration effects stressed by the economic geography literature and to focus on those arising from exchange rate variability and market size in the presence of price rigidities, trade costs are not introduced.
As the aim is to focus on the real consequences of exchange rate variability, the framework is kept simple at the expense of a proper formalization of the financial sector of the economy. Ideally, exchange rate movements would be caused by shocks originating in financial markets. A decrease in demand for financial assets of one country (for example, due to expected policy changes) would cause a depreciation of the currency of that country: the capital outflow would then be associated with a trade surplus. One can think of the model’s features as a reduced form of this more extensive setup.
Equivalently one could assume that w is set so as to equalize the approximate expected real wage across locations. The price indexes are identical across locations (no trade costs) apart from the exchange rate components, which are random and enter nonlinearly. By approximating the expectation of a nonlinear function as the nonlinear function of the expected values, the approximate expected price indexes are identical across locations. Hence, the nominal wage will be identical across locations.
Agents in different countries need to be distinguished, as they may face different prices.
Henceforth simply ‘varieties.’
Money in the utility function in a one-period model is conceptually an asset and technically a good.
For the purposes of the paper, this setup is equivalent to assuming that risk-averse agents care about the expected utility from profits.
Note that ηk represents both market and employment share of country k, but the agglomeration effect deriving from the market share is more important than the one from the employment size.
For any employment allocation, the wage will be determined by the number of firms (demand for labor) compatible with zero expected profits in all markets. Such expected profits would depend on the price, and hence on the wage, in a highly nonlinear fashion, as the price enters the demand and the variability of sales.
Unless special correlation effects are at work.
I owe to discussions with Eswar Prasad the idea of looking at the relation between variability of industrial production and country size in order to investigate the effect of the exchange rate regime on the aforementioned variability.
Australia, Austria, Belgium, Canada, Finland, France, Greece, Germany, Ireland, Italy, Japan, Luxemburg, Netherlands, Norway, Portugal, Spain, United Kingdom, United States.
As all observations are in U.S. dollars, the difference between real and nominal GDP is a constant in the cross section regression.
The shortcoming of FDI is that its crude definition does not allow a clear differentiation between investment and portfolio decisions. FDI is classified as foreign ownership of more than 10 percent of ordinary shares or voting power.
Other key assumptions are: incomplete pass through and repatriation of profits.
Considering flows of FDI between each country and the rest of the world, the effective exchange rate is the relevant variable through which to analyze the effect of exchange rate variability, as it is a trade-weighted average of the bilateral exchange rates. As the intuition derived from the theoretical framework is based on nominal exchange rate variability in the presence of price rigidities, the nominal exchange rate is adopted.
Because of the data availability Luxembourg has been dropped out of the sample.