State dependent price setting and monetary non-neutrality in a small open economy

Koca, Yakup Kutsal
State dependent pricing literature draws inferences for the monetary non-neutrality in the class of closed economy models. The assumption that the economy is closed potentially leads to a mismeasurement of the monetary non neutrality by disregarding the fluctuations in output due to international trade. To this end, I study a small open economy built around firms operating under menu costs to understand the contribution of the open economy factors to the non-neutrality of money. The model environment consists of households, firms and a monetary process along with the rest of the world, altogether which constitute a general equilibrium. Essentially, general equilibrium framework allows capturing the movements in the relative prices driven by the exchange rate, as well as shifts in consumption that reflects the wealth effects induced by relative prices. I compare the model results with a closed economy state dependent pricing and open economy Calvo pricing model that generates price stickiness with time dependent pricing. Results indicate that allowing an economy to engage in the international trade may yield stronger output effect, hence larger monetary non-neutrality. On the other hand, comparison with the Calvo pricing model implies that the discrepancy in monetary non-neutrality generated by state dependent and time dependent pricing models weaken on the basis of how open an economy is along with the selection effect induced in the state dependent pricing model.