Macroeconomic Interdependence with Trade and Multinational Activities Lilia Cavallari* Abstract This paper examines how differences in the integration strategies followed by firms active in foreign markets affect the way productivity and policy shocks spread their effects worldwide.The analysis incorporates costly trade and local sales by multinational firms in a general-equilibrium open economy macroeconomic model. The mode of foreign market access is found to play a major role in the international business cycle, affecting the dimension of consumption and output spillovers worldwide.We show that despite financial markets being effectively complete, consumption risks may not be fully insured in the world economy as long as multi- national firms discriminate prices across markets. Furthermore, cross-country differences in firms’ integration strategies can account for extensive asymmetries in the way country-specific and global shocks are transmit- ted in the world economy.We argue that this may have relevant consequences for the welfare implications of monetary and trade policies. 1. Introduction This paper incorporates costly exports and local sales by multinational enterprises in a new open economy model with the aim of investigating the macroeconomic implica- tions of cross-country differences in the mode of serving foreign markets. The mode of foreign market access has attracted growing attention in the trade literature, with a number of recent contributions focusing on the determinants of entry behavior by multinational corporations. 1 Much less attention has been typically devoted to the issue in international macroeconomics, at least until a novel generation of general-equilibrium open economy models has emerged where foreign market access is at the forefront. One line of research investigates the determinants of firms’ entry and exit decisions in an environment characterized by nominal rigidity and/or trade costs, with only a very limited number of papers in this area allowing for multi- national activities. 2 A second approach stresses the macroeconomic implications of frictions in international goods markets arising from trade costs, as in Obstfeld and Rogoff (2000), and from multinational sales as in Devereux and Engel (2001) and Cavallari (2004). The present paper contributes to the latter line of research by pro- viding a unified framework that conveniently nests earlier models with trade costs and models with internationalized production. Specifically, our study investigates whether the way firms access foreign markets, through trade or with sales by local affiliates of multinational corporations, matters for the international transmission of changes in productivity, monetary policy and trade liberalization policies. The paper considers a two-country world economy in the tradition of the “new open economy” literature where markets are characterized by monopoly distortions and * Cavallari: University of Rome III, DIPES,Via Chiabrera, 199, 00146 Rome, Italy.Tel: 39-065 733 5327; Fax: 39-065 733 5282; E-mail: cavallar@eco.uniroma3.it. I wish to thank two anonymous referees, Alessandro Calza, Bartosz Markowiak, and participants in the 9th ICMAIF conference, the ECB workshop on “Glo- balisation and Regionalism” and the CFSifo–Delphi conference on “Global Economic Imbalances: Prospects and Remedies” for many useful comments.The usual disclaimer applies. Review of International Economics, 16(3), 537–558, 2008 DOI:10.1111/j.1467-9396.2008.00744.x © 2008 The Author Journal compilation © 2008 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA