Money, exchange rate and export quality

Abstract

This paper theoretically examines the effect of an expansionary monetary policy on export quality and its ramifications on the aggregate employment of the unskilled workers in a competitive general equilibrium framework of a small open economy. This issue assumes relevance since monetary policies are often pursued by the central bank of an economy to manage exchange rate fluctuations under a managed float regime, which may have adverse consequences for export-quality choices and thereby for export growth given the growing preference of buyers in richer nations for higher qualities of goods they consume. Under optimal allocation of wealth over a portfolio of cash, domestic assets and foreign assets, we show that an increase in the domestic money supply affects the choice of export-quality primarily in two ways. One is through larger investment, capital formation and consequent endowment effect; the other is through changes in the nominal exchange rate. Under less price-elastic demand for a non-traded good, the export quality is upgraded when higher quality varieties of the export good are relatively capital intensive. On the other hand, though the expansionary monetary policy may raise the aggregate employment of unskilled workers due to its endowment effect, may lower it through changes in the quality of the export good. The overall effect is thus ambiguous. A larger initial size of bequests has a similar effect.