Endogenous Trade Participation with Incomplete Exchange Rate Pass-Through

This paper investigates the implications of endogenous trade participation for international business cycles, trade flow dynamics and exchange rate pass-through when price adjustments are staggered across firms. I develop a two-country dynamic stochastic general equilibrium model wherein firms make state-dependent decisions on entry and exit in the export market and the frequency of price adjustment is time-dependent. Consistent with recent empirical findings at the firm and sectoral levels, producers of traded goods in this model differ in their productivities, trade status and prices. At the aggregate level, quantitative properties of the model successfully reproduce some important characteristics of international business cycle moments in data. In contrast to previous findings in the literature, my model reveals that the inclusion of exporter entry and exit generates notable changes in trade dynamics following aggregate shocks, such as large, immediate responses of the number of exporters, export volumes and export price index. I trace this result to the micro-level price stickiness present in my model but absent in existing models of endogenous trade participation. Micro price rigidity reduces the extent to which changes in the prices of existing traded goods absorb changes in the value of exporting following a persistent macroeconomic shock, and instead permits substantial movements in the benefits of exporting and hence the extensive margin of trade. This suggests that market structure and pricing conventions may be critical in analyzing the role of endogenous trade participation for international business cycles. Moreover, I show that productivity heterogeneity rather than price rigidity plays a dominant role in firms’ export decisions, and hence the additional realism of endogenous trade participation in the model does not mitigate incomplete exchange rate pass-through arising from nominal rigidity. I would like to thank Julia Thomas for invaluable advice and many insightful discussions that have greatly improved this work. I am also grateful to Aubhik Khan for helpful suggestions and guidance. I would also like to thank Paul Evans and seminar participants at the Ohio State University, the Bank of Canada, the Federal Reserve Banks of Dallas and Cleveland, and Bowling Green State University, and session participants at the 2012 Midwest Macro Meetings for helpful comments. The views expressed in this paper are my own and do not reflect those of the Bank of Canada. Any remaining errors are my own. ∗Email: [email protected]