小型開放經濟體系下之政府公債與最適貨幣政策及財政政策

行政院國家科學委員會專題研究計畫 期末報告

小型開放經濟體系下之政府公債與最適貨幣政策及財政政

策

計 畫 類 別 ： 個別型

計 畫 編 號 ： NSC 101-2410-H-004-016-

執 行 期 間 ： 101 年 08 月 01 日至 102 年 07 月 31 日

執 行 單 位 ： 國立政治大學經濟學系

計 畫 主 持 人 ： 黃俞寧

計畫參與人員： 碩士級-專任助理人員：楊馥菁

博士班研究生-兼任助理人員：劉世夫

博士班研究生-兼任助理人員：林學宏

報 告 附 件 ： 出席國際會議研究心得報告及發表論文

公 開 資 訊 ： 本計畫涉及專利或其他智慧財產權，1 年後可公開查詢

中 華 民 國 102 年 10 月 31 日

中 文 摘 要 ： 最近的歐洲債務危機顯示了貨幣政策與財政政策之間的緊密

關係。本研究的目的即在於探

討在一小型開放經濟體系中之政府公債，特別是 debt-GDP 比

例的設定對於總體經濟的影響。我們藉由一個具有三種市場

不完全機制 (獨占性競爭、名目僵固性與所得稅) 的小型開

放動態隨機一般均衡 (DSGE)

模型來探討在不同的經濟開放程度之下，debt-GDP 比例的施

行是否會有不同的總體經濟效果。研究結果發現， debt-GDP

比例的改變將使政府財政政策(稅與政府支出)產生相應變

動。在一開放程度較低的國家，其對於國內經濟會有較大的

影響，而造成較劇烈的總體經濟變動。

中文關鍵詞： 財政政策，公債比重，開放經濟

英 文 摘 要 ： The objective of this research is to examine the

public debts in a small open economy, in line with

the recent debate on the European debt crisis. We use

a small-open-economy dynamic stochastic general

equilibrium (DSGE) model with three types of market

distortions including monopolistic competition,

nominal rigidity, and distortionary income tax to

examine the macroeconomic effects of the debt-GDP

ratio in countries with different degrees of economic

openness. The numerical analyses show that the

increase in the debt-GDP ratio in a less open economy

will result in more drastic changes in government

spending and thus will be less likely to stabilize

the responses of macroeconomic variables in response

to the technology shock.

行政院國家科學委員會補助專題研究計畫

 成 果 報 告

□期中進度報告

（計畫名稱）

小型開放經濟體系下之政府公債與最適貨幣政策及財政政策

計畫類別： 個別型計畫 □整合型計畫

計畫編號：NSC 101 － 2410 － H － 004 － 016

－

執行期間： 101 年 08 月 01 日至 102 年 7 月 31 日

執行機構及系所：政治大學經濟系

計畫主持人：黃俞寧

共同主持人：無

計畫參與人員：楊馥菁、劉世夫、林學宏

成果報告類型(依經費核定清單規定繳交)：



精簡報告 □完整報告

本計畫除繳交成果報告外，另須繳交以下出國心得報告：

□赴國外出差或研習心得報告

□赴大陸地區出差或研習心得報告

 出席國際學術會議心得報告

□國際合作研究計畫國外研究報告

處理方式：

除列管計畫及下列情形者外，得立即公開查詢

□涉及專利或其他智慧財產權， 一年□二年後可公開查詢

中 華 民 國 102 年 10 月 31 日

1

Macroeconomic Implications of Debt Policy in a Small Open

Economy

Yu-Ning Hwang

1

Department of Economics

National Chengchi University

October 2013

ABSTRACT

The objective of this research is to examine the public debts in a small open

economy, in line with the recent debate on the European debt crisis. We use a

small-open-economy dynamic stochastic general equilibrium (DSGE) model with

three types of market distortions including monopolistic competition, nominal rigidity,

and distortionary income tax to examine the macroeconomic effects of the debt-GDP

ratio in countries with different degrees of economic openness. The numerical

analyses show that the increase in the debt-GDP ratio in a less open economy will

result in more drastic changes in government spending and thus will be less likely to

stabilize the responses of macroeconomic variables in response to the techonology

shock.

Keywords: fiscal policy

, debt-GDP ratio, open economy

JEL Classifications: E61; E62; E63

1 *

_{Yu-Ning Hwang is an Assistant Professor in the Department of Economics at}

National Chengchi University, Taipei, 116 Taiwan. Comments are most welcome.

Contact details: e-mail to [email protected]; Tel.: 886-2-29393091 ext. 51641.

I am

grateful to Professor Tien-Wang Tsaur, Fu-Sheng Hung and all the participants in the Conference for

the Financial Crisis and the seminar at the Central Bank of the Republic of China (Taiwan) for helpful

comments and suggestions.

2

1. Introduction

The government debt has become the primary concerns of the world since 2009

when some countries in the Euro area such as Greece, Ireland and Italy, encountered

rapid and significant rises in public debts, as shown by Figure 1. The sovereign risks

that occurred to the European countries has been largely attributed to the absence of

exchange rate adjustment for individual member countries. Due to the absence of

exchange rate devaluation, it is difficult to offset the adverse impacts of negative

shocks on the countries in the Euro area. As a result, the exports, and thus the outputs,

decline upon adverse shocks. In the lack of control of monetary policy, bailout

projects became the primary measures to survive from the economic downturns.

Unavoidably, the rise in the government expenditure and the decline in the tax

revenue resulted in high deficits and accumulated a tremendous amount of public

debts. This crisis is a vivid example to demonstrate the close relationship between the

monetary and fiscal policies.

The interature has shown that the fiscal policy, particularly the debt, is closely

related to the monetary policy. Active siscal policies can affect prices and inflation. In

the case of fiscal dominance where the government uses the active fiscal policy and

passive monetary policy, the government sets up the taxes and spending without

considering the binding intertemporal government budget constraint, but issuing debts

for financing purposes. As a result, future seigniorage is required to offset the debt,

and thereby raises prices and inflation.

2

Different from the Ricardian equivalence

where the tax financing or debt financing are indifferent,

3

these policies are identified

as the non-Ricardian fiscal policy, according to Woodford (1996).

4

Furthermore, monetary policy can have direct effects on the public debts. The

interest rate and the price level, which are crucially affected by the monetary policy,

can lead to revaluation of real debts. The recent DSGE models featuring market

imperfections, particularly the nominal rigidity, have showed some important

quantitative implications of the distortions for the public debts. Schmitt- Grohé and

Uribe (2004) point out that the sluggish adjustment of prices may diminish the ability

of the government’s using the monetary policy to influence the prices. In their study in

2

Earlier studies can be seen in Aiyagari and Gertler (1985), Sargent (1982) and Leeper (1991). A

recent study by Aizenman and Marion (2011) shows that the large public debts of the US can be

inflated away. Their analytical results show that a large nominal debt overhang can lead to inflation,

and suggests that when economic growth is slowed, the US debt overhang may induce a persistent

increase in inflation of about 5% that could significantly reduce the debt ratio under persistently slow

economic growth.

3

Please see Barro (1974, 1989), Woodford (1995, 2001).

4

A theory which is directly related to the non-Ricardian fiscal policies is the fiscal theory of price

level (FTPL). Under FTPL, it is shown that the fiscal policy is the primary determinant of price level,

instead of the monetary policy according to the conventional wisdom (Sims (1994), Woodford (1995,

2001), Cochrane (1998)).

3

%

0

25

50

75

100

125

150

175

200

225

250

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

year

France

Germany

Greece

Ireland

Italy

Japan

S i

U it d Ki d

U it d St t

Source: The World Economic Outlook.

Figure 1: The debt-GDP ratio of European countries and Japan, 2000-2010.

2007, Schmitt-Grohé and Uribe stress the unrealistic simplifications of earlier studies

on optimal monetary policy under DSGE models, particularly the absence of capital

accumulation, the lump-sum tax and the balanced government budget because the

design of optimal monetary policy should depend upon the fiscal regime. With the

implementation of a distortionary tax, instead of stylized lump-sum tax, they show

that the welfare-maximizing monetary and fiscal policies are passive.

However, Schmitt-Grohé and Uribe (2004, 2007) do not explicitly discuss the

public debts, but simply use them to offset the fiscal gap between the government

spending and tax due to unbalanced government budget. Leith and Wren-Lewis (2007)

extend their model to examine the public debts for time consistency issue,

5

in line

with various discussions on the debt-GDP ratio specified by the Stability and Growth

Pack (SGP) of the European Monetary Union (EMU) when people doubt whether the

authority can stick with the rule.

6

Their model is followed by Adam and Billi (2008)

who emphasize the implications of endogenous government spending for public debts.

5

Most of the studies assume the monetary and fiscal policies under commitment.

6

The Stability and Growth Pack (SGP) of the EMU sets the rule that the deficit cannot exceed 3% of

the GDP and the outstanding debt cannot exceed 60% of the GDP for the Euro countries. The early

study on the time inconsistency problem can be seen in Woodford (1996).

4

7

Adam (2011) uses the model in Adam and Billi (2008) which features three types of

distortions including nominal rigidity, distortionary tax and monopolistic competition

to examine the dynamics of public debts under optimal monetary and fiscal policies

by using the timeless Ramsey-optimal policy introduced by Schmitt- Grohé and Uribe

(2004). He finds that there are various steady-state equilibriums associated with

different values of initial debt-GDP ratio. In the steady state, the debt does not

influence the optimal interest rate rule of the central bank, but will influence the real

economy. In the short run, the government debt has important implications for the

implementation of both the optimal monetary and fiscal policies as the stabilizer and

thus both of the policies depend on the initial outstanding balance of debts. The

responses of interest rate rises, and both the tax revenue and the debt-GDP ratio to

shocks differ under different initial debt. The debt will converge gradually to zero, the

optimal level. This implies the debt will decline if the initial debt is positive and will

rise if the initial debt is negative. These issues are particularly important for countries

holding massive public debts, such as the US and European countries for the

government to maintain the adequate debt-GDP ratio, particularly under adverse

shocks, and its relevance to the implementation of monetary and fiscal policies.

However, while the public debt issue has been examined under closed economies or

a currency union, it has been rarely examined under an open economy. Past studies on

the debt issue in open economies fall more heavily on the sovereign risk that

emerging economies with high foreign debts instead of the examination of the public

debt management.

8

Some studies try to endogenously generate the procyclical

government spending for emerging economies, consistent with the empirical findings.

For example, by using a small-open-economy DSGE model with incomplete markets,

endogenous fiscal policy and sovereign default premium, Cuadra, Sanchezm and

Sapriza (2010) endogenously determine the procyclical optimal public expenditures

and tax rates. They do not explicitly examine the issue of public debts.

Thus, it would be interesting to investigate the implications of economic openness

for the public debts. Due to the close relationship between the monetary policy and

the public debt, intuitively, the exchange rate movement which is crucially affected by

monetary policy should have critical effects on the real value of government debts,

and thereby generate quantitatively different macroeconomic implications. In

7

The recent debt crises have put the public debt issue to the center of fiscal policy again when the

public debt management can be a real problem. For example, Devereux (2010) examines the public

debt under the liquidity trap in a closed-economy DSGE model. He shows that the government

spending financed by deficits while the bond rate reaches the zero lower bound on nominal interest rate

can be far more expansionary than tax finance. Many others focus on the sovereign risk which is

beyond the scope of our study. We assume that there is not default risk for the government bonds.

8

5

particular, trade and financial openness which allow flows in goods and financial

assets across countries may also have important implication for the debt-GDP ratio

that a government should maintain. Therefore, we will use a small-open-economy

DSGE framework with all three types of market imperfections and examine the

questions that Adam (2011) brings up for a closed economy to investigate how the

government of a small open economy should maintain an adequate debt-GDP ratio,

with an emphasis on the implication of economic openness for the public debts and

the government debts’ effects on the real economy and exchange rate movements.

This paper is structured as follows. In Section 2, we will outline the model. We will

run conduct numerical examinations for the steady states associated with different

level of debt-GDP ratios in Section 3. In Section 4, we will examine the

macroeconomic responses to different shocks under different implementation of

debt-GDP ratios. Section 5 concludes.

2.

Model

In this study, we will examine the public debt issue in a small-open-economy

DSGE model. There are domestic and imported goods. The market for each type of

goods is monopolistic competition. The households can conduct the transactions of

assets on the international asset market, where the borrowing and lending are

frictional. To examine this issue, we assume that the government implements the

fiscal policy, determining the distortionary income tax rate, the government spending

and the public debts, first two of which crucially rely on the level of debt-GDP ratio.

The central bank controls the interest rate which functions two main ways in this

economy. Firstly, the interest rate is the cost of government’s borrowing. Secondly,

controlling interest rate also crucially affect the price level which will also influence

the real debts.

2.1 Goods market

There are two types of consumption goods in the domestic market: the home

tradable and imported goods, each of which is monopolistically competitive. The

representative household consumes the composite goods, which are composed of

domestic goods

C and imported goods

_td

C :

_tf

   



  

1 1 1 1 1

1

    













_

_



       

_



f t d d t d t

C

C

C

, (1)

6

where

0





d



1

represents the ratios of imported and domestic goods in aggregate

consumption,

C

_t

.

 is the intratemporal elasticity of substitution between domestic

and imported goods. The associated demand functions for the domestic and imported

goods are described below:

 

 

d t v d t d t d t

C

P

j

P

j

C

















,

 

 

tf v f t f t f t

C

P

j

P

j

C

















(2)

 

t t d t d d t

C

P

P

C





















,





_t t f t t d f t

C

P

P

e

C





















 1

(3)

where

C

_td

 

j

and

C

_tf

 

j

stand for the domestic goods and imported goods of

variety j .



is the elasticity of substitution among differentiated goods. The

composite consumption index and the corresponding prices are shown as follows:

C

C

 

j

dj

v

i

d

f

v v v i t i t

,

,

1 1 1 1 0















 

P

_ti

P

_ti

 

j

v

dj

1 v

,

i

d

,

f

1 1 1 0













 



, (4)

As a result, the aggregate price level can be written as:

 



 



_



_

_

_









1 1 1 1

1

tf d d t d t

P

P

P

(5)

where

P

_td

 

j

and

P are the home-currency prices of individual and aggregate

_td

domestic goods, respectively,

P

_tf

 

j

and

P are the home-currency prices for the

_tf

imported goods and

P is the aggregate price index. We assume that the provision of

_t

public goods follow the same composition of goods.

The home firm produces goods sold in both the domestic and foreign markets.

The export demand function

C

_tx

 

j

of variety j is assumed to resemble the

domestic demand function, Eq. (2):

 

 

v x t x x t x t t

P

j

C

j

C

P







 







and

*





,



0















 t x t t x t

P

P

X

C

,

(6)

where

P

_tx

 

j

is the firm’s export price in the foreign currency,

P is the aggregate

_tx

7

foreign price index.



is the price elasticity of the aggregate exports.

X

_t

is the

demand for the exports from the small open economy.

2.2 Household problem

We assume that the infinitely-lived household maximizes the expected lifetime

utility based on the consumption and government spending, and the disutility from the

labor supply:





_











_

  t t t t t

G

l

C

u

E

,

,

0 0



(7)

where





 

0,1

is the household’s subjective discount factor.

l is the labor supply

_t

for the production of goods and

G is the public goods provision in the form of

t

aggregate consumption goods. We assume that





 

g

 

t t l t t t t

G

l

C

G

l

C

u

log

1

log

,

,

1



















,

The budget constraint of the households can be described as follows. The

representative household’s income includes the net sale of capital goods, the receipt of

financial assets, the wages for working in both sectors, as well as the revenue from the

sales of products:



t



t t t t t t t d t t t B t t t t t t t t t

A

l

w

l

w

l

P

P

P

B

R

P

B

R

P

B

P

B

C































   

1

* 1 1 1 1 * *

(8)

Here,

w is the real wage and

_t

l is the labor demanded for production.

_t



_t

is the

tax rate.

B and

_t

B

_t

are the non-contingent domestic bond and foreign bond

denominated in foreign currency respectively.

R

_tB_1

and

R

_tB_1

are the nominal interest

rates which

B

_t1

and

B

_t*_1

pay respectively. We assume that the producers take the

producer-currency pricing for exports and thus the law of one price (LOOP) holds

such that

P

_td



e P

_{t t}x

where

e is the nominal exchange rate, expressed in units of the

_t

domestic currency per one unit of foreign currency.

Utility-optimizing households obtain the following first-order conditions:

1 1 1   

_

t t t

R

C

C



, (9)



_



_

 t l t t t

C

l

w

1



1





, (10)

8

Following Kollmann (2002), we assume that the foreign bond rate,

R

_tB

, is equal to

the world interest rate,

R

_t

, plus a factor of





B

_t*

/

P

_t*



/



, which characterizes the

friction on the international financial market:









* * *

/

* _{t t} t B t

P

B

R

R





, (11)

where



is the parameter which captures the degree of capital mobility. A lower



stands for higher capital mobility and



is the steady-state export value,



_*



1

/ P

P

x

_.

2.3 Production and pricing

The firms produce goods by employing labor to satisfy the market demand:

Y

_t



A l

_{t t}

,

(12)

where

A

_t

is the productivity which is subject to the random shock.

G

_t

is the

aggregate government spending.

We assume that firms adopt the Calvo’s (1983) staggered pricing strategy. In each

period, the probability of firms to change the price is

1





. Therefore, the mean

interval of price change is

1

/



1







. At period t , the profit maximization problem of

a typical firm j who can change the price is to choose

P

_td

 

j

to maximize the

profit within the period t and t

 when the price remains valid. The optimal price

z

that a typical firm sets is:

 

 

, 0 , , 0

,

1

z t t t z t z z d t t z t t t z z

E

mc

v

P

v

E





      



_

















_

















(13)

where



t t z,

is the subjective intertemporal elasticity of substitution which can be

written as



t,tz





z

C

t

/

C

tz

.

mc is the marginal cost of production which can be

t

written as

w /

_t

A

_t

.

The price index for the domestic price will evolve following:

 

P

_td 1v





 

P

_td₁ 1v

 



1





 

P



_{t t}d_, 1v

.

(14)

We assume that the export are priced according to the producer-currency pricing

9

(PCP) fashion. Therefore, firms choose the optimal home-currency export price

P ,

_tx

following the same way as

P , and using the exchange rate to transfer into the

_td

foreign-currency price for exports sold abroad.

2.4 Government and monetary policies

The government budget constraint can be written as:

1 1 1   









t t t t t t t t t t

P

B

R

G

l

w

P

B

_

, (15)

where

 

_t

P P

_{t t1}

.

While the fiscal authority controls the implementation of public goods provision,

tax rates, and the issuance of government bonds, the monetary authority controls the

interest rate

R , following the rule specified as below:

_t

















1

1

,

R R R R R

t t t y t S t

R





R



 







  









y



y





e



e



 (16)

2.5 Market clearing condition

The market clearing condition on the goods market can be written as:

 

_

_

 

t t x t v x t x t t t t d t v d t d t d t

X

P

P

P

j

P

G

C

P

P

P

j

P

Y

 



   























































_*

(17)

3

Calibration

3.1 Parameter values

Calibrations are conducted for numerical examination of the macroeconomic

effects under different debt-GDP ratio. We assume a non-inflationary, deterministic

steady state. In our model, due to the financial friction on the international capital

market, the current account is equal to 0 in the steady state. The parameter values are

calibrated to generate steady-state values consistent with Taiwan’s data in the long run.

The debt-GDP ratio is specified as 0.4 in the benchmark case, which is the current

public debt status of Taiwan. The income tax is specified as 0.15, close to 13.6%, the

10

Table 1 : Parameter values

Parameters

Description

value



Subjective

discount

rate

0.99



Income tax rate

0.15

H



Weight of home goods in aggregate consumption

0.7



_{Elasticity of export goods}

₅

x



、



d

_{Elasticity of substitution among differentiated goods}

₆

T



Elasticity of substitution between home and foreign goods

5

N



_{Elasticity of labor supply}

₁



Financial friction on the international capital market

0.0019

N



Disutility of labor supply

7

m



_{Persistence of interest rate rule}

_0.6

m p



、

m y



、

m S



Responses of interest rate rule to inflation, output gap,

exchange rate

0.8, 0,

0.02

average tax rate of 2009 reported by the Ministry of Finance of Taiwan. The disutility

of labor supply,



N

_{, is specified 7 to generate the steady-state employment}

approximating 1/3, the working hours in Taiwan. The share of home goods in the

aggregate consumption is assumed to be 0.7, to capture the home-bias in consumption.



is specified as 0.99, following the conventional setting. Following Kollmann

(2002), the financial friction on the international capital market is assumed to be

0.0019.

3.2 Implication of trade openness for the debt-GDP ratio

In this section, we conduct dynamic analyses to examine whether or not the change

in the debt-GDP ratio in countries with different trade openness can lead to different

responses of the economy to technology shock. Through out, we assume the tax rate

remain at the level of 0.15. The change in the debt-GDP ratio will reflect mostly on

the government spending.

Figure 1 lists the responses of macroeconomic variables, in an economy with

0.1

d





, to a 1% technology shock under the debt-GDP ratio of 0.1 and 0.7

respectively. The AR(1) coefficient is assumed to be 0.85. The increase in the

debt-GDP ratio will lead to a more drastic decline in the government spending,

followed by significant increase in government spending, which causes the import to

move in the same direction. The change in the debt policy does not lead to notable

11

change in other real variables.

Figure 2 examines the same debt-GDP ratios in a less open economy with

0.6

d





. The comparison between these two figures shows clearly how the different

degree of economic openness can lead to different macroeconomic effects of the debt

policy. The increase in the debt-GDP ratio leads to much larger and more volatile

movements in real variables such as output and employment in response to the same

technology shock, primarily caused by the movement of the government spending. In

a less open economy, the impact of the fiscal policy change, falls more heavily on the

domestic economy and thus results in more drastic movement in the domestic real

economy.

4.

Conclusion

In this study, we examine numerically the macroeconomic effects of the debt-GDP

ratio in a small-open-economy DSGE model. The calibration results demonstrate that

an increase in the debt-GDP ratio in a less open economy will have greater impact on

the domestic economy. This does not result in significant change in exchange rate

movement. In the future study, we may conduct more careful welfare examinations of

the debt policies, following Adam (2011), in a small open economy.

12

0 10 20 30 40 -2 -1.5 -1 -0.5 0 0.5 output 0 10 20 30 40 -0.2 0 0.2 0.4 0.6 0.8 consumption 0 10 20 30 40 -3 -2 -1 0 1 employment 0 10 20 30 40 -2 -1.5 -1 -0.5 0 0.5 export 0 10 20 30 40 -2 -1 0 1 2 import 0 10 20 30 40 -1.5 -1 -0.5 0 0.5  e 0 10 20 30 40 -30 -20 -10 0 10 public spending 0 10 20 30 40 -1 -0.5 0 0.5 inflation 0 10 20 30 40 -0.4 -0.3 -0.2 -0.1 0 0.1 interest rate debt-GDP ratio=0.1 debt-GDP ratio=0.7

13

0 20 40 -4 -2 0 2 output 0 20 40 -0.2 0 0.2 0.4 0.6 consumption 0 20 40 -6 -4 -2 0 2 employment 0 20 40 -3 -2 -1 0 1 export 0 20 40 -4 -2 0 2 4 6 import 0 20 40 -1.5 -1 -0.5 0 0.5



e 0 20 40 -30 -20 -10 0 10 20 public spending 0 20 40 -1 -0.5 0 0.5 inflation 0 20 40 -0.3 -0.2 -0.1 0 0.1 interest rate debt-GDP ratio=0.1 debt-GDP ratio=0.7

14

Reference

Adam, K. (2011), “Government Debt and Optimal Monetary and Fiscal Policy”,

European Economic Review, Vol. 55(1), p.p. 57-74.

Adam, K. and R. M. Billi (2008), “Monetary Conservatism and Fiscal Policy”,

Journal of Monetary Economics, Vol. 55(8), p.p. 1376-1388.

Aiyagari, S. R. and M., Gerler (1985), “The backing of government bonds and

monetarism”, Journal of Monetary Economics, Vol. 16(1), p.p. 19-44.

Aizenman, J. and N. Marion (2011), “Using inflation to erode the US public debt”,

Journal of Macroeconomics, Vol. 33(4), p.p. 524-541.

Barro, R. J. (1974), “Are Government Bonds Net Wealth?” Journal of Political

Economy, Vol. 82, p.p. 1095-1117.

Barro, R. J. (1989), “The Ricardian Approach to Budget Deficits”, Journal of

Economic Perspectives, Vol. 3, p.p. 37-54.

Cochrane, J. H. (1998), “A Frictionless View of U.S. Inflation”, NBER

Macroeconomics Annual, Cambridge, MA: MIT Press, p.p. 323-384.

Cuadra, G., J. M. Sanchezm and H. Sapriza (2010), “Fiscal Policy and Default Risk in

Emerging Markets”, Review of Economic Dynamics, Vol. 13(2), p.p. 452-469.

Devereux, M. B. (2010), “Fiscal Deficits, Debt, and Monetary Policy in a Liquidity

Trap”, Working Paper No. 44, University of British Columbia.

Hwang, Y. N., “Financial Friction in an Emerging Economy”, Journal of International

Money and Finance, forthcoming.

Leeper, E. M. (1991), “Equilibria under ‘active’ and ‘passive’ monetary and fiscal

policies”, Journal of Monetary Economics, Vol. 27(1), p.p. 129-147.

Leith, C. and S. Wren-Lewis (2007), “Fiscal Sustainability in a New Keynesian

Model”, Economic Series Working Paper No. 310, University of Oxford.

15

American Economic review, Vol. 72(2), p.p. 382-389.

Schmitt-Grohé, S. and M. Uribe (2004), “Optimal Fiscal and Monetary Policy under

Sticky Prices”, Journal of Economic Theory, Vol. 114(2), p.p. 198-230.

Schmitt-Grohé, S. and M. Uribe (2007), “Optimal Simple and Implementable

Monetary and Fiscal Rules”, Journal of Monetary Economics, Vol. 54(6), p.p.

1702–1725.

Sims, C. A. (1994), “A Simple Model for Study of the Determination of the Price

Level and the Interaction of Monetary and Fiscal Policy”, Economic Theory, Vol. 4,

p.p. 381-399.

Woodford, M. (1995), “Price Level Determinacy without Control of a Monetary

Aggregate”, Carnegie-Rochester Conference Series on Public Policy, Vol. 43(1),

p.p. 1-46.

Woodford, M. (1996), “Control of the Public Debt: A Requirement for Price

Stability?” NBER Working Paper No. 5684, National Bureau of Economic

Research, Cambridge, MA.

Woodford, M. (2001b), “Fiscal Requirements for Price Stability?” Journal of Money,

國科會補助專題研究計畫項下出席國際學術會議心得報告

日期： 102 年 10 月 30 日

一、參加會議經過

本人於當地時間 1 月 3 日下午抵達美國聖地牙哥，4 日下午報告本人與 Prof. Stephen Turnovsky 何

著”Exchange rate pass-through and the effects of tariffs on economic performance and welfare”一文，會後

與該場的 discussants 以及參與者針對相關議題進行了更深入的討論。該場報告亦有台大經濟系陳虹如

教授，中研院經濟研究所廖珮如教授與曾在中研院經濟研究所服務的楊淑珺教授等人參與，主要皆是

財政政策的總體經濟層面的探討，正是本人目前著手進行研究的方向之一，對於未來相關研究的進展

甚有助益。

AEA meeting 向來有許多知名經濟學者針對重要議題進行座談，本人於次日亦參加了另外兩場針

對貨幣政策與歐元區相關議題的會議：

1.

International Policy Coordination in the Euro Area: Towards an Economic and Financial Federation

主持者：JEAN-CLAUDE TRICHET (Banque de France)

Discussants:

DOMINICK SALVATORE (Fordham University)

MARTIN FELDSTEIN

(Harvard University)

ROBERT MUNDELL

(Columbia University)

計畫編號 NSC

101

－ 2410 － H － 004 － 016 －

計畫名稱

Government debt and optimal monetary and fiscal policies in a small open

economy

出國人員

姓名

黃俞寧

服務機構

及職稱

政治大學經濟系副教授

會議時間

102 年 1 月 4 日至

102 年 1 月 6 日

會議地點

美國聖地牙哥

會議名稱

(中文)

(英文) 2013 AEA Annual Meeting

, Jan. 4-Jan. 6, 2013, San Diego, USA

發表論文

題目

(中文)

(英文)

Exchange rate pass-through and the effects of tariffs on economic performance

KENNETH ROGOFF

(Harvard University)

JOHN B. TAYLOR (Stanford University)

JEAN-CLAUDE TRICHET

(Banque de France)

2. After the Crisis: What Did We Learn, and What Should We Teach, about Monetary Policy? (A2)

(Panel Discussion)

Panel Moderator: JANET YELLEN (Federal Reserve Board)

MARTIN EICHENBAUM (Northwestern University)

BENJAMIN M. FRIEDMAN

(Harvard University)

MARK GERTLER

(New York University)

MICHAEL WOODFORD (Columbia University)

參與座談者皆為一時之選，收穫甚豐。

1/4 下午，本人參加了 University of Washington 的校友聚會，欣逢許多於美國求學時代的教授與

舊友。並與目前正在 UCLA Anderson Forecast Center 工作的 William Yu，與他交換了許多對於當前

經濟以及未來前景的看法。此外，本人亦協助系上陳鎮洲老師藉由此次 meeting 為本系進行新聘教師

的面談。

二、與會心得

整體而言，參與此次會議獲益良多。參與者多有舊識，除可敘舊之外，更可交換對於國內外學術界、

與實務的看法。整體來說，因為此一會議與我的研究有高度相關，參與此一會議，不論是對於目前的

學術研究或是未來的研究規劃，包括進一步的貨幣政策、財政政策分析，與目前已在進行的中國大陸

研究，皆有相當的助益。目前我所發表的文章，已為 Journal of International Money and Finance 接受。

三、考察參觀活動(無是項活動者略)

四、建議

五、攜回資料名稱及內容

因為所有論文都有電子檔，因此並未攜回書面資料，需要時上網下載即可。

Exchange rate pass-through and the effects of

tariffs on economic performance and welfare

q

Yu-Ning Hwang

a

, Stephen J. Turnovsky

b,*

a_{National Chengchi University, Taipei 116, Taiwan}

b_{University of Washington, Economics, Seattle WA 98195, USA}

JEL classifications: F13 F41 E42 Keywords: Tariffs Nominal rigidity

Exchange rate pass-through Expenditure switching effect

a b s t r a c t

We develop a stochastic two-country general equilibrium model, where prices are determined under conditions of monopolistic competition to examine the macroeconomic and welfare effects of tariffs on the world economy under alternative nominal rigidities: producer-currency pricing (PCP) and local-currency pricing (LCP) where the exchange rate pass-through is absent. Wefind that the significance of export pricing for the effects of tariffs depends critically upon whether tariffs are anticipated or unanticipated. In the former case both PCP and LCP yield the same outcome as do perfectlyflexible prices, although the mechanism whereby this is achieved is different. In the latter case, the effects of unanticipated permanent tariffs are highly sensitive to the pricing scheme adopted by exporters, leading to a wide range of conflicting outcomes, involving tradeoffs among key parameters.

Ó 2012 Elsevier Ltd. All rights reserved.

1. Introduction

The role of tariffs as a primary policy instrument of protection has a long history dating back to the 1930s and continuing through recent years.1As a result, the macroeconomic consequences of tariffs

q Yu-Ning Hwang is an Assistant Professor in the Department of Economics at National Chengchi University, Taipei, 116 Taiwan. Stephen Turnovsky is the Van Voorhis Professor of Economics at the University of Washington. The authors gratefully acknowledge the constructive comments of two referees.

* Corresponding author.

E-mail address:[email protected](S.J. Turnovsky).

1 _{As a recent example we note that in 2004, the European Union (EU) imposed a retaliatory tariff on U.S. exports for the}

export tax subsidy applied by the U.S. government to U.S. producers. In 2006, the EU placed anti-dumping tariffs on goods imported from China.

Contents lists available atSciVerse ScienceDirect

Journal of International Money

and Finance

j o ur n a l h o m e p a ge : w w w . e l s e v i e r. c om / l oc a t e / j i m f

0261-5606/$– see front matter Ó 2012 Elsevier Ltd. All rights reserved.

http://dx.doi.org/10.1016/j.jimonfin.2012.10.004

have been extensively debated since they werefirst addressed byMundell (1961). Mundell’s analysis and the earliest extensions of his work were static, employing some variant of the Mundell-Fleming model; see e.g.Boyer (1977),Chan (1978),Krugman (1982). The general conclusion to emerge from this approach was that underflexible exchange rates, tariffs are contractionary, the key mechanism generating this being the Laursen-Metzler effect.2Thefirst analysis of tariffs in a dynamic framework wasEichengreen (1981) who, using a currency substitution model, emphasized the intertemporal tradeoffs involved in a tariff. He argued that while the protection provided by a tariff may be expan-sionary in the short run, over time the increase in savings and current account surplus causes a gradual reversal, so that in the long run the tariff will be contractionary.

More recent analyses of tariffs have analyzed them in the context of a macrodynamic model based on intertemporal optimization.Sen and Turnovsky (1989)develop a one sector model and show how a tariff is contractionary both in the short run and in steady state, although it turns out that the long-run responses are sensitive to specifications of the utility function. Recognizing the diverse effects that tariffs may have on different parts of the economy, several papers have introduced tariffs into a multi-sector framework, thereby highlighting the role of the multi-sectoral adjustments to the tariff; seeGavin (1991)andTurnovsky (1991).Brock and Turnovsky (1993)introduce tariffs into a two-sector specific factors model and focus particularly on the welfare aspects. Among the propositions they establish, they show that a uniform tariff levied on both consumption and investment goods will raise welfare in the short run but reduce it over time. More recently,Fender and Yip (2000)analyze the effects of tariffs in the two-country“new open economy model” pioneered byObstfeld and Rogoff (1995,1996). Their model features imperfect competition and nominal rigidity and shows that the tariff decreases both the output and employment. The impact of a permanent tariff on welfare faces tradeoffs, mainly from its impacts on output and consumption through the terms of trade movement.3

All the literature we have cited assumes either implicitly or explicitly that nominal export prices are set in terms of the currency of the country in which the goods are produced. That is, the literature assumes that export prices are set by producers in terms of their own currency, by employing producer-currency pricing (PCP), as it is known. Under PCP, producers adjust prices completely in accordance with exchange rate movements and thus there is complete exchange rate pass-through onto the prices paid by consumers in the importing country. Purchasing power parity therefore holds for all traded goods.

In practice, however, the empirical evidence supporting exchange rate pass-through implicit in PCP pricing is mixed. On the one hand, several studies have suggested the incomplete exchange rate pass-through onto prices, particularly in the short run. Early supporting evidence supporting this was provided byMussa (1986)andKnetter (1989).4More recent evidence of sluggish prices and the failure of PPP using a wide range of data sets has been provided by others; see e.g.Engel (1993,1999),Campa and Goldberg (2005), and Atkeson and Burstein (2008).5 This evidence suggests that pricing in exporters’ currency, and thereby implying complete exchange rate pass-through, is not the only way for invoicing trade, but rather that denomination in importers’ currency is also a prevalent alternative. That is, exporters may adopt local-currency pricing (LCP), in which case purchasing power parity does not hold and there is no exchange-rate pass-through onto prices paid by importers.

2 _{The Laursen-Metzler effect describes the mechanism whereby a deterioration in the terms of trade reduces real income,}

thereby reducing savings, and given the level of investment, leads to a deterioration in the current account.

3 _{Other related references includeKimbrough (1982),Gardner and Kimbrough (1989),Engel and Kletzer (1990)),Ostry}

(1991), andYip (1995). One characteristic of the literature is that there is no consensus regarding the theoretical effects of tariffs on key macroeconomic variables, afinding that tends to be confirmed empirically byOstry and Rose (1992).

4 _{An early study byKnetter (1989)comparing US and German export pricingfinds producer prices of US firms to be}

insensitive to exchange rate movements and German producer prices to be more sensitive.

5 _{There are many factors that may account for the failure of PPP. For example,Obstfeld and Rogoff (2000)argue that}

deviations from PPP may arise from the presence of nontraded goods in the aggregate price index, as well as from LCP. Moreover they argue that the observed correlations between terms of trade and exchange rate are more consistent with PCP than with LCP. They also cite direct empirical evidence suggesting that for most major economies the national currency remains the principal currency used for denominating national exports. However, they also acknowledge that the practice of invoicing exports in the importer’s currency is increasing over time, except for the United States.

Y.-N. Hwang, S.J. Turnovsky / Journal of International Money and Finance 33 (2013) 81–102 82

Some recent studiesfind contrasting degrees of exchange rate pass-through in the case of United States exports and imports. For example,Goldberg and Tille (2008)find that US firms denominate their exports in US dollars, while most US imports are also denominated in US dollars. In other words, US firms engage in PCP when it comes to their exports, while non US firms that export to the US often price in US dollars, and thus adopt LCP.6Thisfinding is a manifestation of the role of the US dollar as the international currency for trade denomination, a consequence of which is the prevalence of both PCP and LCP in the pricing of exports.7

Recent work byDevereux and Engel (2003),Obstfeld (2008), andEngel (2011)has demonstrated how the pricing of exports has important consequences for monetary policy.8,9With tariffs impacting directly on the price of imports, the currency in which the underlying export price is determined by exporters clearly becomes important and relevant. Yet, despite the widespread use of LCP in practice, and the potential importance of exchange rate pass through in determining the impact of tariffs, there is no literature examining tariffs under this alternative, and widely adopted, pricing scheme where the prices that the consumers face do not immediately change with the exchange rates.10This is somewhat surprising in light of the fact that tariffs are a key factor driving long-run exchange rate movements, and that alternative degrees of exchange rate pass-through can be critical for policy makers.

The objective of this paper is to compare the macroeconomic consequences of a tariff under the two alternative pricing schemes, PCP and LCP. While the empirical evidence suggests that in practice the pricing of exports lies somewhere in between, focusing on these two polar extremes sharpens the contrast between them and facilitates the intuition. For this purpose, we employ a two-country DSGE model with monopolistic competition and nominal price rigidity, initially developed byDevereux and Engel (2003). We assume that both countries can impose a tariff and our objective is to evaluate its effects on both the domestic and the foreign economy. We focus particularly on the effects of the tariffs on equilibrium prices, consumption, and output, but also discuss the consequences for economic welfare.

Our approach is to begin with the case of perfectlyflexible prices as a benchmark and then to characterize the general structure of the equilibrium under the two pricing schemes, taking account of their respective associated nominal rigidities. The main differences pertain to the updating of forecasts of future tariffs, made between time t
1, when prices are set, and time t, when the tariff is put into effect. The primary differences between the PCP and LCP schemes result from the fact that the lack of exchange rate pass-through in the latter case insulates large segments of the domestic economy from the foreign tariff.

Wefind that there is a sharp contrast between the effects of unanticipated and anticipated tariffs in terms of their sensitivity to the pricing of exports. In the case of fully anticipated tariffs, the pricing is

6 _{Their result is also supported byGopinath and Rigobon (2008),Gopinath et al. (2010), and others.}

7 _{The significance of the currency in which trade is denominated has attracted wide attention, and accordingly several recent}

studies have investigated the determinants of currency denomination for trading. For example,Bacchetta and van Wincoop (2005)find that less competitive firms in the foreign market (larger market share and fewer differentiated goods), are more likely to use their own currency for denomination. This may help explain the empiricalfindings of the US dollar as a widely adopted international currency in international trade denomination.Goldberg and Tille (2008,2010)also examine various possible determinants in invoicing currencies.

8 _{The importance of the pricing strategies isfirst revealed byDevereux and Engel (2003). They show that the currency in}

which the price is set has important implications for the optimal exchange rate regime. They show that aflexible exchange rate regime is optimal under PCP, while afixed exchange rate regime is optimal under LCP.Obstfeld (2008)points out that this result ofDevereux and Engel (2003)is due to the symmetric reactions of consumption to idiosyncratic shocks in the absence of nontradable goods. In an economy with nontradable goods, the monetary authorities in these two countries set divergent interest rate rules and thus nominal exchange rateflexibilities are needed for the asset market to achieve the equilibrium where uncovered interest parity holds.

9 _{The implication of international currency for optimal monetary policy is also examined byDevereux et al. (2007). They}

construct a two-country dynamic stochastic general equilibrium (DSGE) model where US producers adopt PCP, while producers from the rest of the world employ LCP.

10_{Novy (2010)uses a two-country New Open Economy Model where some of thefirms take PCP and others take LCP to}

examine the effects of the iceberg trade cost. Hefinds that the different degrees of exchange rate pass-through do not significantly alter the international correlation. Instead of emphasizing the business cycle properties, this study attempts to examine analytically the role of the exchange rate pass-through in the macroeconomic effects of the tariff.

essentially irrelevant, with the effects of tariffs being independent of how export prices are set. In that case, an increase in the domestic tariff under the alternative pricing schemes reduces overall domestic consumption by the same proportionate amount and has no effect on foreign consumption, though the mechanism by which this is accomplished is very different. Under PCP prices adjust completely in accordance with exchange rate movements, while under LCP they are the result of direct pricing decisions by exporters.

Second, for all forms of pricing a perfectly anticipated domestic tariff has both an expansionary effect on domestic output and a contractionary effect, with the former dominating if and only if the intertemporal elasticity of substitution is less than unity. On the other hand, the foreign tariff has an unambiguously contractionary effect on domestic output. This is because in all cases the Foreign tariff reduces Foreign demand for Home goods, although the precise mechanism whereby this occurs differs under the alternative pricing schemes.

In contrast, the effects of unanticipated permanent tariffs are highly sensitive to the pricing scheme adopted by exporters. With producers having pre-set the price in the period prior to the tariff, the aggregate domestic price index increases in response to either domestic or foreign tariffs under PCP, and while under LCP it also increases in response to a domestic tariff, the lack of exchange rate pass-through in that case insulates it against a foreign tariff. A parallel comparison applies to aggregate consumption. In all cases, the effects of unanticipated tariffs are sensitive to the intensity of monetary policy’s response to the aggregate price level, which plays a potentially important role in determining whether tariffs are expansionary or contractionary. Again, because of the role of the exchange rate pass-through effect, it is possible for an unanticipated domestic tariff to be expansionary under LCP but contractionary under PCP, and conversely for a foreign tariff.

The_{final issue is welfare, which depends positively on consumption and negatively on output via} employment and foregone leisure. Welfare effects can be assessed by combining the responses of consumption and output to tariff changes and, in the case of unanticipated tariffs their effects are also highly sensitive to pricing. The fact that tariff policy in one country impacts welfare abroad raises the potential for strategic tariff-setting, although that is not addressed here.

The remainder of the paper is structured as follows. Section2outlines the analytical framework, while in Section3, we evaluate the effects of the tariff underflexible prices, viewed as a benchmark. We introduce the alternative specification of nominal rigidities, PCP and LCP, in Section4and characterize the general equilibrium price, exchange rate, and consumption responses to tariffs under alternative degree of exchange rate pass-through, while Section 5 focuses on the corresponding production responses. Section6discusses in detail the two polar cases of anticipated and unanticipated permanent tariff increases, including their welfare effects. Finally, we present our conclusions in Section 7. As will become evident, despite the simplicity of the model, its analysis involves substantial technical detail, which is provided in anAppendixavailable online.

2. The analytical framework

The analytical framework we employ is an adaptation of the framework ofObstfeld (2008)extended to include the imposition of tariffs.11

2.1. Production

There are two countries, Home and Foreign. Each country produces a continuum of both tradable and nontradable goods, where YHand YHdenote the Home tradable goods sold in Home and Foreign,

respectively, and YNdenotes the Home nontraded goods. Analogously, YF, YF, and YN denote Foreign

tradable goods sold in Home and Foreign, and the Foreign nontraded goods respectively. For each type of commodity, the goods market structure is monopolistically competitive. We index each agent in Home by i over the range [0,1] and assume that he produces one differentiated tradable good and one

11_{This framework is itself an adaption ofDevereux and Engel (2003).}

Y.-N. Hwang, S.J. Turnovsky / Journal of International Money and Finance 33 (2013) 81–102 84

differentiated nontraded good, with his labor being the only input in the production process. Thus, agent i’s production functions are specified by12

YH;tðiÞ ¼ AtLH;tðiÞ; YH;t ðiÞ ¼ AtLH;tðiÞ; YN;tðiÞ ¼ AtLN;tðiÞ (1a)

where At is a country-specific productivity shock common to all producers in Home, and agent i’s

allocation of his total labor, Lt(i), satisfies

LtðiÞ ¼ LH;tðiÞ þ LH;tðiÞ þ LN;tðiÞ

¼_A1

t

h

YH;tðiÞ þ YH;t ðiÞ þ YN;tðiÞ

i

(1b)

Aggregating over Home agents yields the corresponding aggregate relationships in Home

YH;t ¼ AtLH;t; YH;t ¼ AtLH;t; YN;t ¼ AtLN;t (1c)

Lt ¼ LH;tþ LH;tþ LN;t (1d)

Parallel conditions hold with respect to production in Foreign, where agents are indexed by i over the range [1,2] and the aggregate relationships in Foreign (denoted by asterisks) are

Y_F;t ¼ A

tLF;t; YF;t ¼ AtLF;t ; YN;t ¼ AtLN;t (2a)

L_t ¼ LF;tþ LF;tþ LN;t (2b)

We denote the natural logarithms of the technology shocks in the two economies, At; At by at; at,

where we assume the latter evolve in accordance with the following AR(1) processes:

at ¼ ð1

h

Þa þ

h

at
1þ εa;t; εa;twN

 0;

s

2 a  (3a) a_t ¼ ð1

h

Þaþ

h

a_t
1þ εa_;t; ε_a_;twN  0;

s

2 a  (3b)

Given the assumption on technology and preferences introduced below, the assumption of the lognormal distribution of productivity shocks implies that all endogenous variables in the economy are lognormally distributed as well.

2.2. Consumption

Consumers in each country consume a variety of goods, composed of Home and Foreign tradable goods and Home nontradable goods. Any individual i in Home consumes the composite consumption index, C, of the Cobb_{–Douglas form:}

Ct ¼

Cg_T;tC1
_N;tg

g

g_ð1

_g

_Þ1
g (4)

where CTand CNare the indexes of traded and nontraded consumption and

g

is the share of spending

on tradable goods in the total expenditure PC.

12 _{The assumption of stochastic non-diminishing labor productivity, uniform across the traded and nontraded sectors (also}

adopted byDevereux and Engel, 2003; andObstfeld, 2008) is made purely for simplicity and is of little consequence. This is because under monopolistic competition, equilibrium outputs are determined by consumption demand, so that (1a) and (1b) determine the corresponding demand for labor. The only aspect of our results that this specification impacts is the welfare effects which are dependent upon employment, and here the effects are quantitative rather than qualitative.

The inclusion of nontraded goods is important for several reasons. First, nontraded goods are quantitatively significant. Moreover, they help generate the home bias which is prevalent in practice, and which asWarnock (2003)andObstfeld (2008)discuss, is important in determining the exchange rate movements and welfare implications of monetary policies. In this model, the inclusion of non-tradable goods helps characterize the asymmetric effects of tariffs’ effects in the Home and Foreign countries. Without nontradable goods (or home bias), purchasing power parity will hold for both the flexible price and PCP cases, where the law of one price applies. This, together with the risk-sharing condition (13), will make consumption identical across countries at all times and will eliminate the terms of trade movement which is critical for the differential effects of tariff under alternative pricing schemes.

The tradable consumption sub-index is composed of an equal share of Home and Foreign tradable goods, CHand CF: CT;t ¼ 2CH;t1=2CF;t1=2 (5) where C_H;t ¼ ½Z1 0 C_H;tðiÞðq
1Þ=q_diq=ðq
1Þ_{, C} F;t ¼ ½ Z 2 1 C_T;tðiÞðq
1Þ=q_diq=ðq
1Þ_{, C} N;t ¼ ½ Z1 0 C_N;tðiÞðq
1Þ=q_diq=ðq
1Þ

and

q

is the elasticity of substitution in consumption between goods, with

q

_{> 1.}

We assume that Home imposes a tariff

s

ton imports.13In this case, Home aggregate price index for

the composite consumption good at time t is

Pt ¼ P_T;tg P1
_N;tg; PT;t ¼ PH;t1=2  P_F;tð1 þ

s

tÞ 1=2 ₍₆₎ where PH;t ¼ ½ Z 1 i¼ 0PH;tðiÞ 1
q_di 1
1q_{, PF} ;t ¼ ½ Z 2 i¼ 1PF;tðiÞ 1
q_di 1
1q_{, PN} ;t ¼ ½ Z 1 i¼ 0PN;tðiÞ 1
q_di 1
1q _{and PH,t(i),}

PF,t(i), and PN,t(i) are prices set by producer i with PH,t, PF,tand PN,tbeing the prices of the corresponding

sub-aggregates. The price of imports that Home consumers face, inclusive of the tariff, is (1þ

s

t)PF,t.

Throughout, we shall assume that the tariff is imposed permanently and show how its effects contrast sharply, depending upon whether it is anticipated or unanticipated.14

Assuming that agents choose to allocate among the differentiated goods so as to maximize the corresponding consumption aggregate, Home demand for each commodity can be written as

C_H;tðiÞ ¼  P_H;tðiÞ P_H;t 
q C_H;t; CF;tðiÞ ¼  P_F;tðiÞ P_F;t 
q C_F;t; CN;tðiÞ ¼  P_N;tðiÞ P_N;t 
q C_N;t (7a)

Since all producers face identical conditions they set the same price and produce the same output. Home demand functions for Home and Foreign goods are

C_H;t ¼ 1 2  P_H;t PT;t 
1 C_T;t; CF;t ¼ 1₂  ð1 þ

s

tÞPF;t PT;t 
1 C_T;t (7b)

and Home demand functions for traded and nontraded goods are

13 _{We assume that the tariff is imposed on the producer price, P}

F,tso that consumers pay the tariff-inclusive price, (1þst)PF,t.

However, PF,tdiffers under the different pricing schemes. Specifically, PF;t¼ εtP_F;t, under bothflexible prices and PCP, where

P_F;tadjusts freely underflexible prices, but is predetermined one period ahead under PCP. In the case of LCP, foreign firms predetermine PF,tin the Home currency. Whether or not the tariff is anticipated generates the difference in producer prices, and

thereby the consumption price and consumption levels underflexible and predetermined prices.

14 _{Temporary tariffs can be analyzed similarly and the contrasts are similar to those of permanent tariffs.}

Y.-N. Hwang, S.J. Turnovsky / Journal of International Money and Finance 33 (2013) 81–102 86