Production Networks, Exchange Rates and Monetary Policy

Exchange rate policy is central to the monetary policy debate. According to the International Monetary Fund (IMF) report, less than 25% of its members employ flexible exchange rate regimes, although Friedman (1953) calls for exchange rate flexibility. Whether the policymaker should implement a fixed exchange rate largely depends on the welfare cost induced by exchange rate movements.

The exchange rate’s dual role in the goods and financial markets implies that two types of distortions coexist. First, in reality, firms have monopolistic power and price to markets. They choose a different export price from the domestic price, leading to efficiency loss because of the deviation from the law of one price. Ideally, in an efficient economy, firms should not distort the market by setting disparate price. Second, with financial frictions in their production procedure, firms cannot use the resource efficiently. Exchange rate fluctuations generate inefficiency because of the financial frictions when firms borrow in foreign currency.

Because of dual distortions of exchange rates, the first deputy director of IMF, Gopinath and her colleagues suggest the limit of exchange rate flexibility. The academic literature has seldom addressed two distortions simultaneously. This proposal aims to characterize the exchange rate’s dual distortions. Notably, these distortions are at the firm-level. Existing studies assume that a representative firm can adequately characterize the aggregate effect of exchange rate distortions. However, this assumption is questioned by recent production network literature, which argues that the network architecture may amplify or attenuate the aggregate effect of the micro-level distortions.

A primary research question of this proposal is to explore how international production networks determine the macroeconomic response to micro-level distortions induced by exchange rates. The project aims to revisit traditional views on exchange rate flexibility and stability within a framework that includes international input-output linkages. It seeks to understand the dual role of exchange rates in both the goods and financial markets and their aggregate effects on the economy.

Analytical solutions and the loss function are to be derived to highlight the precise welfare cost of exchange rate movement and the role of production network architecture. Provided the analytical solutions, the project will derive the optimal policy and explore the necessity of exchange rate flexibility. Lastly, quantitative exercises are provided to compare the welfare costs of various monetary policies. Policy implications for RMB internationalization and the exchange rate regimes in Hong Kong will be provided.