Academic journal article Journal of Economics and Economic Education Research

Open Economy Keynesian Macroeconomics without the Lm Curve

Academic journal article Journal of Economics and Economic Education Research

Open Economy Keynesian Macroeconomics without the Lm Curve

Article excerpt

INTRODUCTION

Recent developments in the field of Macroeconomics have not been fully incorporated into the available textbooks. Certainly, the "canonical" New Keynesian model (see, e.g., Galí, 2008), currently representing the prevailing orthodoxy in academic circles, includes, together with an IS function, a monetary policy rule and an aggregate supply function based on the Phillips curve. However, the use with didactic purposes of a model of this kind when teaching intermediate Macroeconomics is not common.

In a paper published some years ago, David Romer proposed to replace "the LM curve, along with its assumption that the central bank targets the money supply, with an assumption that the central bank follows a real interest rate rule" (Romer, 2000, p. 150). Assuming the real interest rate is an increasing function of the inflation rate, he obtained an MP (for monetary policy) function, horizontal in the real interest rate-output space that, when coupled with a traditional IS function, led to a decreasing aggregate demand (AD) function in the inflation rate (instead of price level)-output space. The model was completed with the assumption that inflation rises when output is above its natural rate and falls when output is below its natural rate, which gave a horizontal inflation adjustment (IA) line in the inflation-output space. Put together, the IA-AD functions provided an alternative to the AS-AD model, in terms of the inflation rate instead of the price level. Finally, some extensions were also discussed; in particular, the analysis of the open economy was referred to a companion paper available online at the author's web page, where he presents a model with a monetary rule for both the closed and the open economy, but considering only the aggregate demand side for the latter. The first version of that paper, designed to accompany Mankiw's (2012) textbook (first edition published in 1992), dates from August 1999, and the most recent one from January 2012 (Romer, 2012). Similar points were also made by Taylor (2000) and Walsh (2002), but they did not deal with the case of the open economy.

Since then, some (but very few, and mostly European) Macroeconomics textbooks have incorporated a monetary policy rule instead of the LM function, together with an aggregate supply function derived from the Phillips curve; which implies that the AS-AD model is defined as a relationship between the level of output and the rate of inflation, instead of the price level. While this has resulted in a more realistic approach, the analysis has been mostly applied to the closed economy. And, when the open economy was introduced, its treatment has not been substantially different from the closed economy case, in particular regarding aggregate supply.

In this paper, we present a proposal of analysis of the open economy within a framework that incorporates a monetary policy rule instead of the LM function, extended to describe the case of a monetary union. The model comes from a recently published textbook (Bajo-Rubio and Díaz-Roldán, 2011b), aimed to teach Macroeconomics at an intermediate level. We begin by examining how the available Macroeconomics textbooks have dealt with the depiction of monetary policy from the determination of the interest rate through a rule followed by the central bank. Then, we turn to present in greater detail the main features of the approach followed along the book, in order to extend to an open economy framework the model with a monetary policy rule.

MONETARY POLICY RULES IN MACROECONOMICS TEXTBOOKS

As far as we know, the first textbook to introduce a macroeconomic model including a monetary policy rule instead of an LM function is S0rensen and Whitta-Jacobsen (2010) (first edition published in 2005). In general, their approach is similar to ours, with the supply side based on imperfect competition features, where workers set wages and firms set prices; and the model is developed for the open economy. …

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