We study trade policy in a two-sector Krugman (1980) trade model, allowing for production, import and export subsidies/taxes. We consider non-cooperative and cooperative trade policy, first for each individual instrument and then for the situation where all instruments can be set simultaneously, and contrast those with the efficient allocation. While previous studies have identified the home market externality, which gives incentives to agglomerate firms in the domestic economy, as the driving force behind non-cooperative trade policy in this model, we show that this, in fact, is not the case. Instead, the incentives for a non-cooperative trade policy arise from the desire to eliminate monopolistic distortions and to improve domestic terms of trade. As a consequence, terms-of-trade externalities remain the only motive for international trade agreements in the Krugman (1980) model once a complete set of instruments is available.
We study trade policy in a two-sector Krugman (1980) trade model, allowing for wage, import and export subsidies/taxes. We study non-cooperative trade policies, first for each individual instrument and then for the situation where all instruments can be set simultaneously, and contrast those with the efficient allocation. We show that in this general context there are four motives for non-cooperative trade policies: the correction of monopolistic distortions; the terms-of-trade manipulation; the delocation motive for protection (home market effect); the fiscal-burden-shifting motive. The Nash equilibrium when all instruments are available is characterized by first-best-level wage subsidies, and inefficient import subsidies and export taxes, which aim at relocating firms to the other economy and improving terms of trade. Thus, the dominating incentives for non-cooperative trade policies are the fiscal-burden-shifting motive and terms-of-trade effects.
This paper revisits the question of the appropriate domain of a currency area using a New-Keynesian open economy model in which the world is split into two areas, each framed as a continuum of small open regions. We show that the adoption of a common currency like the euro can be beneficial for the members of the monetary union, since the spill-over effects generated by the inflationary policies of the small open economies are likely to outweigh the costs of not tailoring monetary policy to country-specific shocks. We also show that while the enlargement of the monetary union to another group of small open economies can bring about welfare gains for all countries involved, monetary integration of two large economies, such as the euro area and the U.S., will not. These findings can help to rationalize the process of the creation and enlargement of multi-country currency areas like the eurozone.
A two area dynamic stochastic general equilibrium model is employed to investigate the welfare implications of losing monetary independence. Two policy regimes are compared: (i) in one area there is a common currency, while in the other area countries still retain their autonomous monetary policy; (ii) there are two monetary unions. When chosen by national authorities, monetary policy can stabilize optimally the effects of country-specific shocks. However, in that case, policy decisions internalize neither the spillover effects on consumers living in the same area nor their impact on the world economy. Thus the adoption of a common currency implies a trade-off between the cost of not tailoring monetary policy to single country economic conditions and the gains entailed by the improvement upon the conduct of national monetary policies. Our results show that under markup shocks and plausible calibrations, there may be welfare gains from adopting a common currency.
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