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We study how trade linkages affect the conduct of monetary policy in a two-country model with heterogeneous firms, endogenous producer entry, and labor market frictions. We show that the ability of the model to replicate key empirical regularities following trade integration—synchronization of business cycles across trading partners and reallocation of market shares toward more productive firms—is central to understanding how trade costs affect monetary policy trade-offs. First, productivity gains through firm selection reduce the need for positive inflation to correct long-run distortions. As a result, lower trade costs reduce the optimal average inflation rate. Second, as stronger trade linkages increase business cycle synchronization, country-specific shocks have more global consequences. Thus, the optimal stabilization policy remains inward looking. By contrast, sub-optimal, inward-looking stabilization—for instance too narrow a focus on price stability—results in larger welfare costs when trade linkages are strong due to inefficient fluctuations in cross-country aggregate demand.

We study the macroeconomic effects of protectionism. First, using high-frequency trade policy data, we present fresh evidence on the dynamic effects of temporary trade barriers. Estimates from country-level and panel VARs show that protectionism acts as a supply shock, causing output to fall and inflation to rise in the short run. Moreover, protectionism has at best a small positive effect on the trade balance. Second, we build a small open economy model with firm heterogeneity, endogenous selection into trade, and nominal rigidity that successfully reproduces the VAR evidence. The model highlights the importance of aggregate investment dynamics and micro-level reallocations for the contractionary effects of tariffs. We then use the model to study scenarios where temporary trade barriers have been advocated as potentially beneficial, including recessions with binding constraints on monetary policy easing or in the presence of a fixed exchange rate. In all the scenarios we consider, protectionism is not an effective tool for macroeconomic stimulus.

We study the consequences of different degrees of international financial market integration and exchange rate policies in a calibrated, medium-scale model of the Korean economy. The model features endogenous producer entry into domestic and export markets and search-and-matching frictions in labor markets. This allows us to highlight the consequences of financial integration and the exchange rate regime for the dynamics of business creation and unemployment. We show that, under flexible exchange rates, access to international financial markets increases the volatility of both business creation and the number of exporting plants, but the effects on employment volatility are more modest. Pegging the exchange rate can have unfavorable consequences for the effects of terms of trade appreciation, but more financial integration is beneficial under a peg if the economy is subject to both productivity and terms of trade shocks. The combination of a floating exchange rate and internationally complete markets would be the best scenario for Korea among those we focus on.

This paper explores the effects of labor and product market reforms in a New Keynesian, small open economy model with labor market frictions and endogenous producer entry. We show that it takes time for reforms to pay off, typically at least a couple of years. This is partly because the benefits materialize through firm entry and increased hiring, both of which are gradual processes, while any reform-driven layoffs are immediate. Some reforms – such as reductions in employment protection – increase unemployment temporarily. Implementing a broad package of labor and product market reforms minimizes transition costs. Importantly, reforms do not have noticeable deflationary effects, suggesting that the inability of monetary policy to deliver large interest rate cuts in their aftermath – either because of the zero bound on policy rates or because of the membership in a monetary union – may not be a relevant obstacle to reform. Alternative simple monetary policy rules do not have a large effect on transition costs.

We study the consequences of product and labor market reforms in a two-country model with endogenous producer entry and labor market frictions. We focus on the role of business cycle conditions and external constraints at the time of reform implementation (or of a credible commitment to it) in shaping the dynamic effects of such policies. Product market reform is modeled as a reduction in entry costs and takes place in a non-traded sector that produces services used as input in manufacturing production. Labor market reform is modeled as a reduction in firing costs and/or unemployment benefits. We find that business cycle conditions at the time of deregulation significantly affect adjustment. A reduction of firing costs entails larger and more persistent adverse short-run effects on employment and output when implemented in a recession. By contrast, a reduction in unemployment benefits boosts employment and output by more in a recession compared to normal times. The impact of product market reforms is less sensitive to business cycle conditions. Credible announcements about future reforms induce sizable short-run dynamics, regardless of whether the announcement takes place in normal times or during an economic downturn. Whether the immediate effect is expansionary or contractionary varies across reforms. Finally, lack of access to international lending in the wake of reform can amplify the costs of adjustment.

We study the consequences of offshoring for international equity portfolios, risk sharing, and the international transmission of technology and government spending shocks. We show analytically that serving foreign markets by producing locally can substitute for international asset trade and terms of trade adjustment in delivering perfect risk sharing across countries: Offshore production implies that the consumption differential is tied to the real exchange rate even if the optimal equity portfolio is fully home-biased and the elasticity of substitution between domestic and foreign goods in consumption is different from one. Net foreign assets do not move in response to shocks. We investigate how the extent to which firms use source- versus host-country technology when producing abroad matters for the international transmission of shocks. A numerical illustration allows us to compare transparently the properties of our model to those of the alternative environment in which firms serve foreign markets by exporting.

What will be the internal and external effects of euro area market reforms? Will increased market flexibility in Europe affect incentives for the conduct of macroeconomic policy by European policymakers and their partners? We address these questions in a two-country model with heterogeneous plants, endogenous producer entry, and labor market frictions. We interpret the two countries in our model as the euro area and the U.S. We find that market reforms in the euro area will result in increased producer entry and lower unemployment on both sides of the Atlantic, but a worse European external balance, at least for some time. With high market regulation in the euro area, optimal monetary policy requires significant departures from price stability both in the long run and over the business cycle, and a higher inflation target in the euro area than in the U.S. The adjustment to market reforms requires expansionary monetary policy, and more expansion in reforming Europe than in the already flexible U.S. However, deregulation reduces static and dynamic inefficiencies, making price stability more desirable everywhere once the transition is complete.

We study the consequences of economic reforms in New Zealand since the beginning of the 1990s. Inflation targeting became the monetary policymaking framework of the RBNZ in 1990. In the years that followed, New Zealand implemented labor market reform and became increasingly integrated in world trade. We use a New Keynesian model with rich trade microfoundations and labor market dynamics to study the performance of inflation targeting versus alternative monetary policy rules for New Zealand in relation to these market characteristics and reforms. We show that nominal income targeting would have been a better choice than inflation targeting or price-level targeting prior to market reforms by delivering more stable unemployment dynamics in a distorted economic environment. Nominal income targeting would also have been better than inflation targeting with respect to the transition costs of labor market reforms, though inflation targeting allowed for better management of the transition after trade integration. With New Zealand in its new long-run environment of integrated trade and flexible labor markets, the welfare gap between nominal income targeting and price/inflation targeting declines, as market reforms lower unemployment volatility.

This paper studies the impact of product and labor market reforms when the economy faces major slack and a binding constraint on monetary policy easing---such as the zero lower bound. To this end, we build a two-country model with endogenous producer entry, labor market frictions, and nominal rigidities. We find that while the effect of market reforms depends on the cyclical conditions under which they are implemented, the zero lower bound itself does not appear to matter. In fact, when carried out in a recession, the impact of reforms is typically stronger when the zero lower bound is binding. The reason is that reforms are inflationary in our structural model (or they have no noticeable deflationary effects). Thus, contrary to the implications of reduced-form modeling of product and labor market reforms as exogenous reductions in price and wage markups, our analysis shows that there is no simple across-the-board relationship between market reforms and the behavior of real marginal costs. This significantly alters the consequences of the zero (or any effective) lower bound on policy rates.

This paper introduces a new empirical model of international trade flows based on an import intensity-adjusted measure of aggregate demand. We compute the import intensity of demand components by using the OECD Input-Output tables. We argue that the composition of demand plays a key role in trade dynamics because of the relatively larger movements in the most import-intensive categories of expenditure (especially investment, but also exports). We provide evidence in favor of these mechanisms for a panel of 18 OECD countries, paying particular attention to the 2008–2009 Great Trade Collapse. (JEL E23, F14, F17, F44, G01)

We examine the effect of non-zero, steady-state foreign assets on consumption dynamics in response to productivity shocks in a two-country, dynamic, general equilibrium model. The model generates non-zero steady-state net foreign assets by allowing for different discount factors across countries. As a consequence of discounting differences, individual steady-state consumption profiles are tilted upward or downward. Worldwide shocks to long-run productivity levels lead to dynamics that are absent in standard, symmetric models with equal discount factors. We then compare the model results to those of a VAR in common trend representation for the U.S. versus the rest of the G7. In the data, we find that permanent worldwide productivity shocks lead to net foreign asset and consumption dynamics that are broadly consistent with interpreting the U.S. as the relatively impatient model economy and are not consistent with symmetric models with equal discount factors.

This paper develops a small open economy, sticky-price model that determines a unique, stable long-run asset position for households as function of their incentive to anticipate or postpone consumption and labor effort across periods. This is accomplished by adopting an overlapping-generations structure in which new households with no assets enter the economy in each period. The same characteristics of household behavior that determine long-run assets are also important determinants of the model's responses to shocks. Stabilizing producer prices results in a milder recession following a drop in world demand than stabilizing consumer prices because it prevents the markup in the pricing of goods from increasing. In addition, given an initial foreign debt, allowing consumer prices to rise causes a decrease in the ex post real interest rate on impact, lowering the interest burden of the initial debt. The differences across policy rules generated by the initial asset position are robust to changes in the latter as long as these are brought about by changes in parameter values that do not alter the fundamental characteristics of household (and firm) behavior that are also the key determinants of long-run assets.

This paper shows that properly designed interest rate rules can be consistent with maintaining exchange rate stability. It sheds light on the relation between interest rate rules, exchange rate regimes, and determinacy of the rational expectation equilibrium in a modern macroeconomic framework.

We use a two-country, stochastic, general equilibrium model of international trade and macroeconomic dynamics with monopolistic competition and heterogeneous firms to explore the role of entry in the domestic economy and the extensive margin of international trade in the dynamics of U.S. trade flows over the business cycle. We show that the model can reproduce the evidence on the cyclicality of U.S. trade and important features of the evidence on the extensive margins of domestic entry and international trade. Entry in the domestic economy and the implied differences in the timing of export and import expansions in response to favorable productivity shocks provide the key mechanism for the model's ability to explain this range of stylized facts.(This abstract was borrowed from another version of this item.)

I develop a tractable, two-country, real model of macroeconomic interdependence with a role for net foreign asset dynamics. Absence of Ricardian equivalence in an overlapping generations structure ensures existence of a well-defined, endogenously determined, steady-state, international distribution of asset holdings, to which the world economy returns following temporary shocks. The model offers a plausible explanation for the failure of statistical tests to reject the hypothesis of a unit root in series of net foreign assets. Model dynamics after productivity shocks are significantly different from those of a setup in which net foreign assets do not move after shocks, such as Corsetti and Pesenti's (2001a) model. The difference relative to a complete markets economy in which net foreign asset movements play no role in shock transmission is smaller. It is amplified if the substitutability across goods rises, if shocks are permanent, and if steady-state net foreign assets are not zero.

What inflation rate should the central bank target? We address determinacy issues related to this question in a two-sector model in which prices can differ in equilibrium. We assume that the degree of nominal price stickiness can vary across the sectors and that labor is immobile. The contribution of this paper is to demonstrate that a modified Taylor Principle holds in this environment. If the central bank elects to target sector one, and if it responds with a coefficient greater than unity to price movements in this sector, then this policy rule will ensure determinacy across all sectors. The results of this paper have at least two implications. First, the equilibrium-determinacy criterion does not imply a preference to any particular measure of inflation. Second, since the Taylor Principle applies at the sectoral level, there is no need for a Taylor Principle at the aggregate level.

This very nice paper clearly fits in Devereux’s agenda of promoting exchange rate stability and international monetary cooperation as a better alternative to floating exchange rates and independent, uncoordinated policies. Our first comment has to do with whether or not the paper actually accomplishes this goal. A reader who is familiar with Benigno and Benigno’s (2003) work immediately recognizes from the setup of Devereux’s model that mimicking the flexible price equilibrium under flexible exchange rates is the optimal policy that central banks should commit to pursue to maximize welfare. All assumptions that ensure this result (along with a very elegant analytical solution of the model) are in place: unitary elasticity of substitution between domestic and foreign goods, purchasing power parity (PPP), log utility, subsidies that offset the monopolistic distortion in steady state. Given that the model delivers a clear indication as for what central banks should do, all other policy rules are bound to produce results that are inferior (or at best equal) to those generated by the independent pursuit of the flexible price allocation. Hence, it is not clear to us that the setup of the paper is the best one to argue in favor of exchange rate pegs and policy coordination. Doing so by comparing the outcome under what Devereux calls a cooperative peg to constant money growth rules is not convincing, as one is left wondering why central banks would want to follow such money growth rules in the first place. Perhaps, the more interesting question is how far a properly designed regime of fixed exchange rates leaves the economy from the performance under floating rates and optimal policies. Here, the answer is not far at all.’ The quantitative difference is quite small on welfare grounds.

We develop a model of monetary and fiscal policies appropriate for considering U.S.-European policy interactions in an era of near-balanced budgets and European monetary union. We study the determinants of policy trade-offs and incentives for central banks and governments across the Atlantic. Smaller, more open economies face more favorable trade-offs, since openness enhances policy effectiveness via the exchange-rate channel. Changes in Europe's monetary arrangements do not affect U.S. trade-offs, although they alter the trade-offs facing European policy-makers. Fiscal trade-offs depend crucially on the extent to which fiscal policy is distortionary. Changes in taxes and spending move both employment and inflation in the desired direction following a worldwide supply shock when spending is financed with distortionary taxes.

We show that deviations from long-run stability of product prices are optimal in the presence of endogenous producer entry and product variety in a sticky-price model with monopolistic competition in which price stability would be optimal in the absence of entry. Specifically, a long-run positive (negative) rate of inflation is optimal when the benefit of variety to consumers falls short of (exceeds) the market incentives for creating that variety under flexible prices, governed by the desired markup. Plausible preference specifications and parameter values justify a long-run inflation rate of two percent or higher. Price indexation implies even larger deviations from long-run price stability. However, price stability (around this non-zero trend) is close to optimal in the short run, even in the presence of time-varying flexible-price markups that distort the allocation of resources across time and states. The central bank uses its leverage over real activity in the long run, but not in the short run. Our results point to the need for continued empirical research on the determinants of markups and investigation of the benefit of product variety to consumers.

Smaller firms sell more equity in response to expansions than do larger firms. Also, consumption is more pro-cyclical for high income groups than others. In this paper, we present a model that captures key features of both of these patterns found in recent empirical studies. Managers own firms with unique differentiated products and can sell ownership in these firms. Equity sales require paying consulting fees, but the resulting scrutiny also make firms more efficient. We find four main results: (1) Equity sales are pro-cylical since the benefits of higher profits outweigh the consulting fees during a boom. (2) Equity shares in smaller firms are more pro-cyclical because expansions induce previously solely-owned firms to seek outside equity financing. (3) Households must absorb the increased equity sales by managers, thereby affecting their consumption response relative to managers. (4) Greater underlying managerial inefficiency induces more firms to seek outside advice and ownership in equilibrium. As a result, the cyclical impact on efficiency is mitigated by outside ownership.

This paper studies the domestic and international effects of national bank market integration in a two-country, dynamic, stochastic, general equilibrium model with endogenous producer entry. Integration of banking across localities reduces the degree of local monopoly power of financial intermediaries. The economy that implements this form of deregulation experiences increased producer entry, real exchange rate appreciation, and a current account deficit. The foreign economy experiences a long-run increase in GDP and consumption. Less monopoly power in financial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution effects in labor supply in response to productivity shocks. Bank market integration thus contributes to moderation of firm-level and aggregate output volatility. In turn, trade and financial ties allow also the foreign economy to enjoy lower GDP volatility in most scenarios we consider. These results are consistent with features of U.S. and international fluctuations after the United States began its transition to interstate banking in the late 1970s.

We show that the employment-inflation tradeoff facing a central bank depends on the size of the economy for which it sets monetary policy. For inflation-averse central banks, the tradeoff improves the smaller the relevant economy. The tradeoff facing the region whose central bank controls the exchange rate in a managed exchange rate regime does not change moving to a symmetric flexible exchange rate regime. Instead, the core region in an asymmetric regime faces a worse tradeoff than under flexible exchange rates. Equipped with these results, we explore the issue of the optimal size of a currency area both in a two and in a three-region world. © 1998 Elsevier Science B.V.

The wave of crises that began in 2008 reheated the debate on market deregulation as a tool to improve economic performance. This paper addresses the consequences of increased flexibility in goods and labor markets for the conduct of monetary policy in a monetary union. We model a two-country monetary union with endogenous product creation, labor market frictions, and price and wage rigidities. Regulation affects producer entry costs, employment protection, and unemployment benefits. We first characterize optimal monetary policy when regulation is high in both countries and show that the Ramsey allocation requires significant departures from price stability both in the long run and over the business cycle. Welfare gains from the Ramsey-optimal policy are sizable. Second, we show that the adjustment to market reform requires expansionary policy to reduce transition costs. Third, deregulation reduces static and dynamic inefficiencies, making price stability more desirable. International synchronization of reforms can eliminate policy tradeoffs generated by asymmetric deregulation.

This paper introduces a new methodology for the estimation of demand trade elasticities based on an import intensity-adjusted measure of aggregate demand, with the foundation of a stylized theoretical model. We compute the import intensity of demand components by using the OECD Input-Output tables. We argue that the composition of demand plays a key role in trade dynamics because of the large movements in the most import-intensive categories of expenditure (especially investment, but also exports). We provide evidence in favor of these mechanisms for a panel of 18 OECD countries, paying particular attention to the 2008-09 Great Trade Collapse.

We study Ramsey-optimal scal policy in an economy in which product creation is the result of forward-looking investment decisions by rms. There are two main results. First, depending on the particular form of variety aggregation, rms’ dividend payments may be either subsidized or taxed in the long run. This policy balances monopoly incentives for product creation with the welfare benet of product variety. In the most empirically relevant form of variety

Smaller firms sell more equity in response to expansions than do larger firms. Also, consumption is more pro-cyclical for high income groups than others. In this paper, we present a model that captures key features of both of these patterns found in recent empirical studies. Managers own firms with unique differentiated products and can sell ownership in these firms. Equity sales require paying consulting fees, but the resulting scrutiny also make firms more efficient. We find four main results: (1) Equity sales are pro-cylical since the benefits of efficient production outweigh the consulting fees during a boom. (2) Equity shares in smaller firms are more pro-cyclical because expansions make previously solely-owned firms to seek outside equity financing. (3) Households must absorb the increased equity sales by managers, thereby affecting their consumption response relative to managers. (4) Greater underlying managerial inefficiency induces more firms to seek outside advice and ownership in equilibrium. As a result, the cyclical impact on efficiency is mitigated by outside ownership.

This paper studies the domestic and international effects of the transition to an interstate banking system implemented by the U.S. since the late 1970s in a dynamic, stochastic, general equilibrium model with endogenous producer entry. Interstate banking reduces the degree of local monopoly power of financial intermediaries. We show that the an economy that implements this form of deregulation experiences increased producer entry, real exchange rate appreciation, and a current account deficit. The rest of the world experiences a long-run increase in GDP and consumption. Less monopoly power in financial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution effects in labor supply in response to productivity shocks. Bank market integration thus contributes to a moderation of firm-level and aggregate output volatility. In turn, trade and financial ties between the two countries in our model allow also the foreign economy to enjoy lower GDP volatility in most scenarios we consider. The results of the model are consistent with features of the U.S. and international business cycle after the U.S. began its transition to interstate banking.

Ongoing international financial integration has greatly increased foreign asset holdings across countries, enhancing the scope for a "valuation channel" of external adjustment (i.e., the changes in a country's net foreign asset position due to exchange rate and asset price changes). We examine this channel of adjustment in a dynamic stochastic general equilibrium model with international equity trading in incomplete asset markets. We show that the risk-sharing properties of international equity trading are tied to the distribution of income between labor income and profits when equities are defined as claims to firm profits in a production economy. For a given level of international financial integration (measured by the size of gross foreign asset positions), the quantitative importance of the valuation channel of external adjustment depends on features of the international transmission mechanism such as the size of financial frictions, substitutability across goods, and the persistence of shocks. Finally, moving from less to more international financial integration, risk sharing through asset markets increases, and valuation changes are larger, but their relative importance in net foreign asset dynamics is smaller.

The inefficiencies related to endogenous product creation and variety under monopolistic competition are two-fold: one static—the misalignment between consumers and producers regarding the value of a new variety; and one dynamic—time variation in markups. Quantitatively, the welfare costs of the former are potentially very large relative to the latter. For a calibrated version of our model with these distortions, their total cost amounts to 2 percent of consumption. Appropriate taxation schemes can implement the optimum amount of entry and variety. Elastic labor introduces a further distortion that should be corrected by subsidizing labor at a rate equal to the markup for goods, in order to preserve profit margins and hence entry incentives.

This paper studies the domestic and international effects of financial deregulation in a dynamic, stochastic, general equilibrium model with endogenous producer entry. We model deregulation as a decrease in the monopoly power of financial intermediaries. We show that the economy that deregulates experiences producer entry, real exchange rate appreciation, and a current account deficit. The rest of the world experiences a long-run increase in consumption and an expansion in the number of domestic producers. Less monopoly power in financial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution effects in labor supply in response to productivity shocks. Financial deregulation thus contributes to a moderation of firm-level and aggregate output volatility. In turn, trade and financial ties between the two countries allow the foreign economy to enjoy lower volatility as well. The results of the model are consistent with features of U.S. and international data following the U.S. banking deregulation started in 1977.

International audience; This paper studies the role of endogenous producer entry and product creation for monetary policy analysis and business cycle dynamics in a general equilibrium model with imperfect price adjustment. Optimal monetary policy stabilizes product prices, but lets the consumer price index vary to accommodate changes in the number of available products. The free-entry condition links the price of equity (the value of products) with marginal cost and markups and hence with inflation dynamics. No-arbitrage between bonds and equity links the expected return on shares, and thus the financing of product creation, with the return on bonds, affected by monetary policy via interest rate setting. This new channel of monetary policy transmission through asset prices restores the Taylor Principle in the presence of capital accumulation (in the form of new production lines) and forward-looking interest rate setting, unlike in models with traditional physical capital. We also study the implications of endogenous variety for the New Keynesian Phillips curve and business cycle dynamics more generally, and we document the effects of technology, deregulation, and monetary policy shocks, as well as the second moment properties of our model, by means of numerical examples.

International financial integration has greatly increased the scope for changes in a country's net foreign asset position through the “valuation channel” of external adjustment, namely, capital gains and losses on the country's external assets and liabilities. We examine this valuation channel theoretically in a dynamic equilibrium portfolio model with international trade in equity that encompasses complete and incomplete asset market scenarios. By separating asset prices and quantities in the definition of net foreign assets, we can characterize the first-order dynamics of both valuation effects and net foreign equity holdings. First-order excess returns are unanticipated and i.i.d. in our model, but capital gains and losses on equity positions feature persistent, anticipated dynamics in response to productivity shocks. The separation of prices and quantities in net foreign assets also enables us to characterize fully the role of capital gains and losses versus the current account in the dynamics of macroeconomic aggregates. Specifically, we disentangle the roles of excess returns, capital gains, and portfolio adjustment for consumption risk sharing when financial markets are incomplete, showing how these different channels contribute to dampening (or amplifying) the impact response of the cross-country consumption differential to shocks and to keeping it constant in subsequent periods.

Forthcoming, Journal of Political Economy; International audience; This paper builds a framework for the analysis of macroeconomic fluctuations that incorporates the endogenous determination of the number of producers and products over the business cycle. Economic expansions induce higher entry rates by prospective entrants subject to irreversible investment costs. The sluggish response of the number of producers (due to sunk entry costs and a time-to-build lag) generates a new and potentially important endogenous propagation mechanism for real business cycle models. The return to investment (corresponding to the creation of new productive units) determines household saving decisions, producer entry, and the allocation of labor across sectors. The model performs at least as well as the benchmark real business cycle model with respect to the implied second-moment properties of key macroeconomic aggregates. In addition, our framework jointly predicts procyclical product variety and procyclical profits even for preference specifications that imply countercyclical markups. When we include physical capital, the model can simultaneously reproduce most of the variance of GDP, hours worked, and total investment found in the data.

We study the efficiency properties of a dynamic, stochastic, general equilibrium, macroeconomic model with monopolistic competition and firm entry subject to sunk costs, a time-to-build lag, and exogenous risk of firm destruction. Under inelastic labor supply and linearity of production in labor, the market economy is efficient if and only if symmetric, homothetic preferences are of the C.E.S. form studied by Dixit and Stiglitz (1977). Otherwise, efficiency is restored by properly designed sales, entry, or asset trade subsidies (or taxes) that induce markup synchronization across time and states, and align the consumer surplus and profit destruction effects of firm entry. When labor supply is elastic, heterogeneity in markups across consumption and leisure introduces an additional distortion. Efficiency is then restored by subsidizing labor at a rate equal to the markup in the market for goods. Our results highlight the importance of preserving the optimal amount of monopoly profits in economies in which firm entry is costly. Inducing marginal cost pricing restores efficiency only when the required sales subsidies are financed with the optimal split of lump-sum taxation between households and firms.

We develop a stochastic, general equilibrium, two-country model of trade and macroeconomic dynamics. Productivity differs across individual, monopolistically competitive firms in each country. Firms face a sunk entry cost in the domestic market and both fixed and per-unit export costs. Only relatively more productive firms export. Exogenous shocks to aggregate productivity and entry or trade costs induce firms to enter and exit both their domestic and export markets, thus altering the composition of consumption baskets across countries over time. In a world of flexible prices, our model generates endogenously persistent deviations from PPP that would not exist absent our microeconomic structure with heterogeneous firms. It provides an endogenous, microfounded explanation for a HarrodBalassa-Samuelson effect in response to aggregate productivity differentials and deregulation. Finally, the model successfully matches several moments of U. S. and international business cycles.