International outsourcing, exchange rates, and monetary policy☆

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.