Working Paper No. 05-15 Vertical Production and Trade Interdependence and Welfare

We study international transmissions and welfare implications of monetary shocks in a twocountry world with multiple stages of production and multiple boarder-crossings of intermediate goods. This empirically relevant feature is important, as it has opposite implications for two external spillover effects of a unilateral monetary expansion. If all production and trade are assumed to occur in a single stage, the conflict-of-interest terms-of-trade effect tends to dominate the common-interest efficiency-improvement effect for reasonable parameter values, so that the international welfare effects would depend in general on the underlying assumptions about the currencies of price setting. The stretch of production and trade across multiple stages of processing magnifies the efficiency-improvement effect and dampens the terms-of-trade effect. Thus, a monetary expansion can be mutually beneficial regardless of its source or the pricing assumptions. JEL classification: E32, F31, F41