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This paper explores the role of trade integration—or openness—for monetary policy transmission
in a medium-scale new Keynesian model. Allowing for strategic complementarities in
price-setting, we highlight a new dimension of the exchange rate channel by which monetary policy
directly impacts domestic inflation: a monetary contraction which appreciates the exchange
rate lowers the local currency price of imported goods; this, in turn, induces domestic producers to
lower their prices too. We pin down key parameters of the model by matching impulse responses
obtained from a vector autoregression on time series for the US relative to the euro area. Our
estimation procedure yields plausible parameter values and suggests a strong role for strategic
complementarities. Counterfactual simulations show that openness alters monetary transmission
significantly. While the contractionary effect of a monetary policy shock on inflation and output
tends to increase in openness, we find that monetary policy’s control over inflation increases, as
the output decline which is necessary to bring about a given reduction of inflation is smaller in
more open economies.
