Finally, one could also consider competition for the international markets
rather than competition in the international markets.15 Traditional models of
patent races are nested in our general framework (see Etro, 2002a, 2004) and
can be used to study trade policy for firms investing in some forms of innovation
to conquer foreign markets. Also in these contexts, export promotion is always
optimal if access to the international competition is free: in this case, subsidies
are simply R&D subsidies as shown in Etro (2006c); for a related analysis see
Impullitti (2006a,b).16
3 Exchange Rate Policy
Our model allows to study another important tool which is used by govern-
ments to promote exports: competitive devaluations. It is commonly taken for
granted that exchange rate devaluations are beneficial to exporting firms, allow-
ing to increase demand for their products and providing a strategic advantage to
them. In this sense, there is a strategic incentive to implement unilateral com-
petitive devaluations directly under fixed exchange rates or indirectly through
a monetary expansion which depreciates the currency when the exchange rate
is flexible. As we will make clear, this is not generally true, but a devaluation
definitely gives a strategic advantage to exporting firms when free entry holds
in the foreign markets.
Our model of imperfect competition between international firms for a for-
eign market is particularly useful for such a purpose, since it is consistent with
international market segmentation, which allows firms to choose different prices
for different markets (in particular the price of a good in domestic currency
does not need to be the same in the domestic and the foreign market).17 Hence,
following Dornbusch (1987), we can endogenize the effects of variations in the
nominal exchange rate on prices. The effects of exchange rate policy for ex-
porting firms crucially depend on the location of production, on whether local
currency pricing or producer currency pricing holds18 and on the strategic re-
action of firms to the policy. In our partial equilibrium context, we will focus
on the strategic effects of a devaluation on the domestic firm. Clearly, a de-
valuation has other consequences in general equilibrium, but the point here is
just to understand whether the usual claim that a devaluation gives a strategic
advantage to exporting firms is correct.
Our focus will be on a particular situation where all firms produce in their
domestic country, bear production costs in domestic currency, choose their strat-
15See Aghion and Griffith (2005) for a survey.
16 See Etro (2002b) for this point in a general equilibrium model of Schumpeterian growth.
17 In other words, the law of one price does not hold, as usually happens in the real world
because of transport costs and other frictions.
18 See Engel (2000) and Betts and Devereux (2000) for theoretical discussions on local cur-
rency pricing versus producer currency pricing respectively in a standard Mundell-Fleming
model and in a new open macroeconomy model.
15