Working Papers, The Johns Hopkins University, Department of Economics 493
In standard New Keynesian models, the size of the output expansion generated by aggregate demand shocks depends crucially on the elasticity of labor supply which is empirically quite small. In principle, this link can be broken in a multisectoral economy with differing degrees of price stickiness, so that the required increase in labor supply can come from other sectors. This paper reinterprets this line of reasoning in a small open economy with a traded and a non-traded sector. The latter is characterized by monopolistic competition and nominal price stickiness. The main findings of the paper are twofold. It is shown that, in fact, the size of the labor supply elasticity has no significant effect on the output response to a monetary policy shock. Yet, in this open economy framework the puzzle of the output response remains since they occur only for unrealistically high intertemporal substitution elasticities. Furthermore, it is shown that the current account response to an expansionary monetary shock crucially depends on the industrial structure of the money and not, as previously claimed, on consumption preferences alone. For reasonable model specifications the current acount moves into deficit.