Chapter 1 investigates the international production networks channel through which external sectoral shocks are transmitted to a small emerging country—Mexico. In our two-country model, the international production linkages of the emerging economy are explicitly characterized but the country has no economic impact on the large economy (U.S.) because of asymmetric country sizes. Using structural factor analysis, we show that the U.S. financial shocks, especially their idiosyncratic components, account for a significant fraction of GDP fluctuations in Mexico. Importantly, the shocks are transmitted mainly through the international production linkages. We further argue for the necessity of modeling production sharing sectors, in which cross-border inputs are complementary. Lastly,...[ Read more ]

Chapter 1 investigates the international production networks channel through which external sectoral shocks are transmitted to a small emerging country—Mexico. In our two-country model, the international production linkages of the emerging economy are explicitly characterized but the country has no economic impact on the large economy (U.S.) because of asymmetric country sizes. Using structural factor analysis, we show that the U.S. financial shocks, especially their idiosyncratic components, account for a significant fraction of GDP fluctuations in Mexico. Importantly, the shocks are transmitted mainly through the international production linkages. We further argue for the necessity of modeling production sharing sectors, in which cross-border inputs are complementary. Lastly, we present empirical evidence on the U.S. financial shocks’ propagation via international production networks.

Chapter 2 studies the role of financial friction in understanding the impact of uncertainty in emerging markets. We find that financial frictions amplify the impact of uncertainty on consumption more than the counterparts on GDP. We explain this finding by stressing the role of durable consumption. With an increase in financial frictions, durable consumption but not nondurable consumption, declines much more than output in response to uncertainty shocks. These findings are new in emerging market business cycle literature. To connect with the literature, we develop a small open economy real business cycle model with banking sectors. In the model, uncertainty shocks results in positive change of real interest rate. And financial friction governs the interest rate’s sensitivity to the uncertainty shocks. Through this mechanism, the model is able to rationalize the empirical findings. In addition, Bayesian estimation reveals that uncertainty shocks are important in driving the business cycles of Mexico.

Chapter 3 discusses the role of international fiscal policy coordination in a New-Keyesian Open Economy Framework. Empirical evidence suggests that for many countries, retail prices of traded goods are sticky in national currencies. Movements in exchange rates then cause deviations from the law of one price, and exchange rate misalignment, which cannot be corrected by monetary policy alone. This paper shows that a state contingent international tax policy can be combined with monetary policy to eliminate exchange rate misalignment and sustain a fully efficient welfare outcome. But this monetary-fiscal mix cannot be decentralized with non-cooperative determination of monetary and fiscal policy. Non-cooperative use of taxes and subsidies introduces strategic spillovers which opens up a fundamental conflict between the goals of output gap and inflation stabilization and those of terms of trade manipulation in an open economy. The implementation of an efficient monetary-fiscal mix requires effective cooperation in fiscal policy, while leaving monetary policy to be determined non-cooperatively. In addition, while an efficient outcome requires state contingent taxes and subsidies to eliminate exchange rate misalignment, it is still necessary to have flexible exchange rates and independent monetary policy.