Essays on sticky price models of the international business cycle.

The first part of my dissertation is entitled “Sticky Import Prices or Sticky Export Prices: Theoretical and Empirical Investigation,” and connects two bodies of evidence. First of them tests directly, in which currency prices should be assumed to be sticky in a sticky price model of an international business cycle. The second body of evidence concerns an important implication of sticky export prices. At present, the literature on sticky-price international business cycles is divided into two major camps. The first camp assumes sticky export prices, normally combined naturally with the lawof-one-price (LOP). The second camp assumes stickiness of import prices, normally obtained from pricing to market (PTM) and local-currency-pricing (LCP). These two assumptions may lead to drastically different conclusions, of which one example is the implications for the slope of the Phillips curve, as is demonstrated in the same paper. Therefore, I use vector-autoregressive (VAR) methodology to investigate, which of these two assumptions describes the world better. I analyze the relative realism of the two assumptions by studying the responses of the terms of trade, import prices, and export prices, to exogenous monetary policy and exchange rate shocks. Clearly, the two assumptions have opposing predictions for response of import and export prices, and consequently, for short-term responses of the multilateral terms of trade, defined at the ratio of import and export prices. The choice of econometric methodology – vector autoregression – is driven by the fact that I am investigating the relative merits of the two assumptions for purposes of business cycle research. Hence, I am interested in the reaction of the aggregate price indices, as well as in the timing of the responses. Besides, VAR methodology allows to identify, conditional on a set of assumptions, exogenous shocks to monetary policy or exchange rates. This method contrasts with those used in the microeconomic studies, which have demonstrated deviations from the law of one price and imperfect exchange rate path-through for a variety of individual goods. My finding is that import prices react stronger than export prices to monetary and exchange rate shocks in Canada and the United States. At the same time, both of these indices react stronger than the general price level. Hence, I conclude that both LOP and LCP type behavior is present in these two economies, but LOP behavior dominates, and hence sticky export prices are a more realistic choice for the form of price stickiness in a model of an international business cycle. I also demonstrate and test an important implication of the finding that import prices react faster to nominal shocks than do domestic prices. I show that in such circumstances, local prices should be characterized by a smaller degree of stickiness in an economy with a high level of import penetration, because the private cost of price stickiness in such economies is higher. This finding bears immediate importance for policy-makers, who operate in open economies, as they need a firm understanding of how the presence of the foreign sector affects their ability to influence the economy through monetary policy. In a way, the paper is a response to a frequent erroneous claim that enhanced competition with the foreign sector brings an era of low inflation and reduces the need of tight monetary policy. The private cost of price stickiness is higher in open economies, because money shocks, even in a sticky price environment, lead to an immediate adjustment of the exchange rate, and therefore