Global value chain participation and optimal monetary policy in a small open economy

Abstract This paper examines the effects of monetary policy in a small open economy participating in the global value chains by constructing a model with firm heterogeneity and production fragmentation. Liquidity constraints and terms‐of‐trade externality distort the sorting of firms into different operations. Under a flexible exchange‐rate regime, changes in domestic interest rate can affect the distribution of firms across different trade modes, the economy's processing and ordinary trade flows, and economic welfare. The presence of processing trade is shown to alter the monetary policy trade‐off. When the domestic interest rate is the only policy instrument available, the second‐best optimal interest rate will be zero (positive) in the case with a sufficiently low (high) output elasticity of imported input in the production of final‐good export. The ability of the Friedman rule to address the distortions from the terms‐of‐trade externality hinges on the relatively higher labour intensity in processing than in ordinary production.