Understanding Macroeconomic Interdependence: Do We Really Need to Shut Off the Current Account?

This paper develops a small open economy, sticky-price model with a role for current account dynamics in the transmission of shocks. I solve the stationarity problem of incomplete markets, open economy models by adopting an overlapping-generations structure. I model nominal rigidity by assuming that firms face costs of output price inflation volatility. Markup dynamics affect labor demand and investment decisions. To illustrate the functioning of the model, I identify the home economy with Canada and analyze how a recession in the U.S. is transmitted to Canada under alternative inflation targeting rules. Stabilizing inflation (in consumer or producer prices) at a steady-state target in all periods results in a milder, but more persistent recession than a rule under which the interest rate reacts to inflation in a Taylor fashion. Markup dynamics and changes in asset holdings are central to this result.