Does Monetary Policy Matter for Trade?

This paper offers empirical evidence to shed light on the trade creation effect of inflation targeting regime. The existing empirical literature mostly focuses on the effect of exchange rate arrangements on trade. Bacchetta and van Wincoop (2000), however, highlight the important role of monetary policy on trade with a full equilibrium model. The literature on the effect of price and cost uncertainty on the behavior of risk-averse firms also suggests a possible negative effect of price level uncertainty on trade. Using the standard gravity model, we find that an inflation targeting regime has a trade creation effect on bilateral trade, but the effect is much more moderate than that under exchange-rate targeting. Unlike a direct peg, however, the moderate effect of inflation targeting exists in the bilateral trade between an inflation targeter and all of its trading partners. This moderate effect is therefore much larger at the multilateral level, suggesting the inflation targeting regime may not have a lower level of total trade than the exchange-rate targeting regime. This view is further supported by an empirical analysis of total trade under the two monetary policy regimes.