International outsourcing, exchange rates, and monetary policy

https://doi.org/10.1016/j.jimonfin.2021.102461Get rights and content

Highlights

  • This paper studies the macroeconomic implications of international outsourcing.

  • The presence of international outsourcing can dampen the effects of monetary policy.

  • Outsourcing explains the perverse effect of currency revaluation on trade balance.

  • The distributional welfare effects of international outsourcing can be substantial.

  • With outsourcing, optimal policy consists of Friedman rule and a fixed exchange rate.

Abstract

Firms’ decisions to outsource the production of intermediate inputs abroad depend on the macroeconomic environment set by governments’ monetary and foreign exchange policies, while the relocations of production change liquidity demands in the financial markets and affect policy effectiveness. This paper studies theoretically the interdependence of firms’ sourcing decisions and governments’ conducts of policies. By constructing a two-country, monetary model with segmented financial markets to incorporate the microeconomic foundations of firms’ make-or-buy decisions and highlight the working capital needs of both buyers and suppliers of intermediate inputs, the endogenous adjustments of international outsourcing at both the extensive and intensive margins are examined. It shows that the adjustments at the intensive margin of firms’ sourcing decisions will dampen the effects of temporary monetary shocks under a fixed exchange rate if the firms face low upfront payments to their foreign suppliers. The adjustments at the extensive margin can alter qualitatively the impacts of a currency revaluation and help explain the perverse effect on the trade balance. Implementing the Friedman rule and a fixed exchange rate regime can address both margins so that the socially optimal allocation can be achieved.

Introduction

International outsourcing has become an important phenomenon in globalization.1 Domestic firms outsource to unaffiliated foreign suppliers to take advantage of lower costs of labor and intermediate inputs abroad. The effects of these international transactions on the flows of goods and labor have been studied extensively in the theoretical literatures on international trade and labor economics.2 However, the financial dimension of the transactions has been largely neglected; and the implications of international outsourcing for the macroeconomy and for the conducts of monetary and foreign exchange policies have received relatively little attention. Understanding the macroeconomic implications of firms’ make-or-buy decisions theoretically can provide some essential guidance to policymaking and rationale for empirical studies.

The relocation of production of intermediate inputs affects the liquidity demands in the domestic and foreign loan markets, while monetary and foreign exchange policies influence the availability of liquidity in the financial markets. Their interactions result in real effects on the world economy. It is important for the firms to understand how these policies affect their tradeoffs between in-house production and sourcing abroad. It is also crucial for the policymakers to recognize the impacts of the presence of international outsourcing on the transmission channels of their policies. The investigation of this interdependence would provide new insights into the impacts of temporary monetary policy shock and the perverse effect of currency revaluations on the trade balance. It also helps illustrate the dependence of socially optimal policy on the presence of international outsourcing.

This paper incorporates the microeconomic foundations of firms’ make-or-buy decisions into a two-country, monetary model with segmented financial markets to highlight two key features of international outsourcing. First, a firm’s decision to use an imported intermediate input is optional and sensitive to the economic environment. Second, firms’ make-or-buy decisions determine not only the locations of production of the intermediate inputs but also the loan markets to which the intermediate good producers seek external financing for their working capital needs.

To emphasize that outsourcing is not necessary but optional, the intermediate inputs produced domestically and abroad are assumed to be perfect substitutes in the model. International outsourcing entails a fixed cost which only firms with higher productivity levels in producing the final good can bear it. Hence, firms’ reliance on the imported intermediate inputs is endogenously determined, the economy can adjust its use of the imported intermediate inputs at not only the intensive margin (the changes in the quantities demanded for imports of the firms that have already been sourcing from abroad) but also the extensive margin (the changes in the number of firms self-selecting into international outsourcing).3 Focusing on the adjustment in the intensive margin, the model shows how the effects of temporary monetary policy shocks are weakened by the presence of international outsourcing. Understanding the adjustments at the extensive margin in response to permanent policy changes such as exchange rate revaluations provides new insights not only into the relationship between firms’ endogenous sourcing decisions and a country’s trade balance, but also the redistributive role of exchange rate policy, allowing policymakers to have better design of welfare-enhancing policy.

In order to highlight the impacts of international outsourcing on liquidity demand in financial markets, we assume cash-in-advance constraints on all transactions and segmented financial markets to model the role of financial flows in facilitating the flows in goods and labor. The cash-in-advance assumption captures the liquidity services provided by money. Financial market segmentation implies asymmetric access to liquidity by different market participants; financial intermediaries channel funds collected from depositors to provide working capital for production and international trade. Monetary non-neutrality works through the working capital (liquidity) channel. Financial frictions affect the relative unit cost of intermediate inputs between the two locations. Our general equilibrium framework demonstrates how the domestic country’s final good production is affected by the supplies and demands of loanable funds in both the domestic and foreign loan markets. To improve efficiency in the world economy, policies must address distortions to liquidity allocations in both loan markets.

To keep the model simple enough to allow for analytical solution, we assume that labor is the sole primary factor of production in the world economy, and that production fragmentation occurs in the final good sector of the domestic country only. Domestic firms can choose between domestic in-house production or international outsourcing. We rule out domestic outsourcing and foreign integration by construction so as to focus on the implications of firms’ make-or-buy decisions on the allocations in the labor and financial markets of both countries.4 The outsourcing relationship involves the domestic firms outsourcing some tasks to arm’s length firms in the foreign country, referred to as the production of the intermediate good for convenience. The value added by foreign labor to the domestic production is therefore measured by the value of the domestic economy’s imports of intermediates.5

The results are summarized as follows. First, under a fixed nominal exchange rate, the effects of monetary shocks is dampened when there are international outsourcing activities and low contractual upfront payment arrangements between the domestic (source) firms and their foreign suppliers. The domestic firms’ decisions to outsource shift the financing of working capital required for the production of the intermediate input from the domestic loan market to the foreign loan market. The lower the upfront payments made by domestic firms, the higher the foreign suppliers’ reliance on the loanable funds in the foreign loan market, and the lower the responsiveness of domestic production to the liquidity shocks in the domestic loan market. Interestingly, this dampening impact of international outsourcing on the effectiveness of the domestic country’s monetary policy does not prevail under a flexible exchange rate, demonstrating the importance of understanding the implications of increasing production fragmentation for policy making.

Second, a foreign currency revaluation leads more domestic firms to outsource abroad and results in an improvement in the foreign country’s trade balance. The general equilibrium adjustment mechanism is the reason behind these counter-intuitive results. When there is no international outsourcing, an increase in the value of foreign currency results in reductions (increases) in the domestic (foreign) households’ demands for imported consumption goods, deteriorating the foreign country’s trade balance. With international outsourcing, a foreign currency revaluation has additional effects via the adjustments of trade in intermediates. The domestic firms that have been outsourcing abroad adjust at the intensive margin by reducing their intermediate imports. As their production of the domestic consumption good decreases, the domestic consumption good price rises substantially, leading some domestic firms to switch from producing their intermediate inputs in-house to outsourcing abroad. The adjustment of the imports of intermediates at the extensive margin plays a dominant role in determining the trade flows, resulting in a perverse effect on the trade balance.

Third, a reduction in the fixed cost associated with outsourcing makes the foreign country better off and the domestic country worse off under both flexible and fixed exchange rate regimes. Given that a revaluation of the foreign currency benefits the domestic country and makes the foreign country worse off, it can be used as a policy tool to redistribute some of the welfare gain of the foreign country to the domestic country so that both countries can benefit from a reduction in the fixed cost of international outsourcing and attain a higher aggregate welfare level. This result highlights the asymmetry in the welfare effects of international outsourcing and illustrates the welfare-redistributive role of a fixed exchange rate regime when there is international outsourcing.

Fourth, solving a social planner’s problem of maximizing the weighted sum of the two countries’ welfare levels yields the socially optimal allocation and helps identify the policy combination that can deliver this allocation in a monetary competitive equilibrium. The optimal policy combination consists of the adoption of the Friedman rule in each country and a fixed (flexible) exchange rate regime when there is (no) international outsourcing. This finding points out the role of firms’ sourcing decisions in affecting the relative merits of fixed and flexible exchange rates.

The remainder of the paper is organized as follows. In Section 2, we discuss the related literature and contributions of this paper. The model is presented in Section 3. Section 4 analyzes the effects of changes in some exogenous variables and discusses how they help rationalize some relevant empirical observations. Section 5 studies the design of optimal policy. Some numerical exercises are presented in Section 6. Section 7 concludes the paper.

Section snippets

Related literature

The international trade of intermediates and vertical specialization have been modeled in the literature of open-economy macroeconomics. Using dynamic stochastic general equilibrium models, Kose and Yi, 2006, Ambler et al., 2002, Kose and Yi, 2001, Head, 2002, Huang and Liu, 2007, Burstein et al., 2008, Arkolakis and Ramanarayanan, 2009 examine the roles of intermediate input trade and vertical structure of production in the propagating mechanism of international business cycles. Following the

The model

Consider a world economy consisting of two countries, home and foreign. All foreign variables and parameters will be indexed with asterisks (∗). There are two final (consumer) goods, x and y, one intermediate input, referred to as good I, and one primary factor of production, labor. Labor is internationally immobile. Each country has a monetary authority and a measure one of ex-ante identical, infinitely-lived, multi-member households. Each household consists of five members: a shopper, an

Analysis

This section analyzes the effects of some exogenous changes on the world economy, helping to provide a theoretical explanation for some empirical relations. First, we will study the effects of temporary monetary and productivity shocks of the home country on the world economy, taking as given the presence of international outsourcing. Second, we will analyze the effects of devaluations/revaluations of the foreign currency on the home entrepreneurs’ outsourcing decisions, the liquidity

Optimal policy

In order to examine the optimal policies of the monetary authorities, we need to define a social welfare function. Assume that the two countries cooperate and maximize a weighted sum of their welfare, UwYU+1-YU, where 0<Y<1 is the weight of the home country in the measurement of the world’s welfare level Uw. Our investigation will proceed in three steps. First, we solve a social planner’s problem to obtain the socially optimal allocation (the social optimum in an environment free of any

Numerical examples

Some numerical exercises are constructed to help illustrate the model’s theoretical properties further. The aim is to highlight the roles of two key parameters, ξ and η, rather than to match the observed data. The analytical results in Section 4.1 show that the fraction of contract payment required upfront, ξ, plays an important role in determining the effects of the temporary liquidity shocks. It would be of interest to find a plausible value of ξ. As reported by the World Bank Enterprise

Conclusions

The paper complements the existing macroeconomic literature on international trade in intermediates by highlighting firms’ make-or-buy decisions and the role of financial flows required to facilitate the international outsourcing activities. A two-country, monetary model with segmented financial markets is constructed to examine the interdependence of firms’ international outsourcing decisions and governments’ conducts of monetary and foreign exchange policies. The theoretical results help

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    I would like to thank an anonymous referee, Menzie Chinn (the editor), and the participants of the Annual Meeting of the Canadian Economics Association, Western Economics 50th Anniversary Conference, and seminar at York University for their helpful comments and suggestions. All errors are mine. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

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