Monopolistic Competition and the Transmission of Demand Fluctuations

Working Papers 114 Honkatukia Juha

Monopolistic competition has received a great deal of attention in recent years as a potential source for demand fluctuations. In closed economy literature, it has established that there are coordination failures present in monopolistic competition that can lead to price rigidities and thus non-neutrality of money. In trade theory, monopolistic competition has been established as a prominent explanation for the actual patterns of international trade. However, these findings have not made their way into open economy macroeconomics. The contribution of the present paper is in extending the model monopolistic competition and endogenous rigidities into open economies. Our analysis implies, that the common belief that endogenous rigidities as such suffice to justify Keynesian open economy models, has no ground. More specifically, the structure of trade effects crucially both the effects of and conditions for rigidities. We consider both the standard pattern of trade in open economy macromodels, that of interindustry trade, and the one dominating modern trade theory, intraindustry trade. The models suggest, that intraindustry trade underlies some central results of open economy macroecnonomics. In the model with monopolistic competition and interindustry trade, there are no demand shifts, that seem to be at the core of traditional macromodels. In the model of intraindustry trade, there are demand shifts and international transmission of demand fluctuations. On the other hand, in the model of intraindustry trade, openness results in spillover effects, that are not present in closed economies and that substantially alter the case for rigidies. Our central finding is that, given intraindustry trade, price rigidities are more likely to appear in open economies than in closed economies, in the sense that the conditions under which rigidities are Nash- equilibria of pricing are less stringent in open economies. Open economies are consequently more likely to be vulnerable to demand fluctuations than closed economies. A further implications of the model is, that if firms in a country have monopoly power in international markets, the country cannot by assumed small in the traditional sense. In the analysis, only one source for rigidities will be considered, namely, menu costs of changing prices. This approach is justified on the basis of a review of closed economy literature on price rigidities. The main source of the paper is Ball and Romer (1987): Sticky Prices as Coordination Failure. NBER discussion paper No 2327.