Academic journal article Federal Reserve Bank of St. Louis Review

Toward a New Paradigm in Open Economy Modeling: Where Do We Stand?

Academic journal article Federal Reserve Bank of St. Louis Review

Toward a New Paradigm in Open Economy Modeling: Where Do We Stand?

Article excerpt

In the last few decades, there have been a number of important developments, both theoretical and empirical, in open economy macro economics and exchange rate economics (see, for example, Sarno and Taylor, 2001a, b). Also, the increasing availability of high-quality macroeconomic and financial data has stimulated a large amount of empirical work. While our understand ing of exchange rates has improved as a result, many challenges and questions remain. This paper selectively surveys the recent literature on "new" open economy macroeconomics. This literature, stimulated by the work of Obstfeld and Rogoff (hereafter OR) (1995), reflects the attempt by researchers to formalize exchange rate determination in the context of dynamic general equilibrium models with explicit micro foundations, nominal rigidities, and imperfect competition. [1]

The main objective of this research program is to develop a new workhorse model for open economy macroeconomic analysis. Relative to the still ubiquitous Mundell-Fleming-Dornbusch (MFD) model (Mundell, 1962, 1963; Fleming, 1962; Dornbusch, 1976), new open economy models offer a higher standard of analytical rigor coming from fully specified micro foundations; they offer the ability to perform welfare analysis and rigorously discuss policy evaluation in the context of a framework that allows for market imperfections and nominal rigidities. On the other hand, the main virtue of the MFD model is its simpler analytical structure, which makes it easy to discuss in policy circles. Because the predictions of new open economy models are sensitive to the particular specification of the microfoundations, policy evaluation and welfare analysis depend on the specification of preferences and nominal rigidities. In turn, this generates a need for the profession to agree on the "correct" or at least "preferable" specification of the microfoundations.

The present paper reviews the key contributions in new open economy macroeconomics in the last five to six years, also assessing how the intellectual debate stimulated by OR has led to models that reflect reality more satisfactorily over time. The paper also discusses some of the most controversial issues that currently still prevent any of the models in this area to emerge as a new paradigm for open economy modeling and describes the directions taken by the latest literature.

The remainder of the paper is set out as follows. The first section provides a review of the seminal paper in this literature, proposing the so-called redux model, while the second section covers a number of variants and generalizations of the redux model that permit allowance for alter native nominal rigidities, pricing to market, alternative preference specifications, and alternative financial markets structures. I then discuss some stochastic extensions of these models, focusing on their implications for the relationship between uncertainty and exchange rates in the third section. Some new directions taken by the latest literature on stochastic open economy modeling are described in the fourth section. A final section presents some concluding remarks.

THE REDUX MODEL

The Baseline Model

OR (1995) is the study often considered as having initiated the literature on new open economy macroeconomics (see, for example, Lane, 1999, and Corsetti and Pesenti, 2001). However, a pre cursor of the OR (1995) model that deserves to be noted here is the model proposed by Svensson and van Wijnbergen (1989). They present a stochastic, two-country, neoclassical rational-expectations model with sticky prices that are optimally set by monopolistically competitive firms, where possible excess capacity is allowed for to examine international spillover effects of monetary disturbances on output. In contrast to the prediction of the MFD model that a monetary expansion at home leads to a recession abroad, the paper suggests that spillover effects of monetary policy may be either positive or negative, depending on the relative size of the intertemporal and intratemporal elasticities of substitution in consumption. …

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