Open Economy Macroeconomics Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Much of the influential research in macroeconomics in the post–Great Depression era has focused on domestic economic fluctuations. For a large country such as the United States, the assumption that foreign interest rates had little effect on domestic economic variables was accepted. Foreign investment and net factor flows were small relative to the domestic economy. Furthermore, the Bretton Woods system of fixed exchange rates ensured that little reason to model currency fluctuations existed. Today, however, understanding linkages between national economies is of critical importance.

The first step toward a serious modeling of open economy macroeconomics came with the introduction of the Mundell-Fleming model, which was an improvement on the basic Keynesian IS-LM structure. Recently, scholars have developed more advanced models based on microeconomic foundations. Some of these models are based on closed economy versions of equilibrium models of the business cycle. Other scholars have attempted to incorporate “sticky prices” into their models in the tradition of New Keynesian macroeconomics.

Whatever the approach, it is crucial to realize that the basic challenges of open economy macroeconomics are that linkages exist between markets and must be respected, and that there are limits to what government policy can accomplish because they cannot control all the variables simultaneously—a problem sometimes referred to as the trilemma.

Models

One possible reason that progress in open economy macroeconomics began rather slowly is that the United States, as the dominant economy, was largely assumed to be able to pursue its own domestic policy objectives without regard for interest rates and other prices in the rest of the world. Hence, research in macroeconomics focused mainly on domestic prices and interest rates. In the Keynesian paradigm, the overriding objective was to understand how active intervention with fiscal and monetary policy could promote economic stabilization.

One basic approach simply adds net exports to the Keynesian model. Domestic spending (absorption) depends positively on domestic income and negatively on the domestic interest rate. Net exports depend positively on foreign income and negatively on domestic income. Real exchange-rate depreciation at home causes domestic goods to become cheaper on the world market and, thus, improves the trade balance. Putting these statements together yields an open economy IS curve.

As a result, for example, an increase in foreign income will increase domestic aggregate demand, causing both domestic output and interest rates to increase. The amount that output and interest rates increase depends on the money market and whether the economy is near full employment.

The Mundell-Fleming model builds on this approach by further specifying that in a world of perfect capital mobility and fixed exchange rates, the situation described above would result in an increase in domestic interest rates relative to world rates and lead to increased capital inflows. The result is a balance-of-payments surplus. As foreign capital rushes in, upward pressure is put on the value of domestic currency. If the economy is small (by definition, an economy that cannot affect world prices or interest rates), this pressure would require the central bank to sell the domestic currency (buy foreign reserves). This action takes the pressure off, discouraging capital inflows and bringing the balance of payments back into balance. As a result, of course, the domestic interest rate would fall back toward the world rate. In the case of perfect capital mobility and fixed exchange rates, the monetary authority of a small open economy is completely at the mercy of external factors.

The monetarist approach takes a somewhat different view. Whereas the Keynesian approach to macroeconomic stabilization policy puts more emphasis on fiscal policy, the monetarist school of thought (associated with Milton Friedman and the University of Chicago) asserts that the supply of money is an important determinant of the balance of payments. Key features of the monetarist approach are that a stable money demand function depends on domestic prices and income. The money supply consists of both the supply circulating in the economy and foreign reserves. Finally, purchasing power parity holds, and money supply equals money demand.

The consequence of the monetarist setup of the model is that given foreign prices and domestic income, money demand remains constant. Therefore, in a fixed-exchange-rate regime, a change in the domestic money supply leads to an equal and opposite change in foreign reserves. As a result, the monetary authority need not intervene in the exchange market but can restore balance-of-payments equilibrium through monetary policy alone.

Both the Keynesian and monetarist approaches can be extended to models of exchange-rate determination under floating exchange-rate regimes. Although these models did much to increase understanding of how international variables (e.g., exchange rates and balance of payments) respond to changes in global economic conditions, they are not based on microeconomic principles. Recent research has focused on modeling international economic relationships, giving special attention to the microeconomic foundations.

Recent Developments

Numerous puzzles in open economy macroeconomics cannot be resolved in the older Keynesian and monetarist frameworks. Among those puzzles is why a home bias tends to exist in both trade in goods and in asset holdings. Another question is why consumption growth across countries is less correlated than standard macroeconomic theory would predict. These puzzles exist because economic models based on perfectly competitive markets and rational optimizing behavior by consumers and firms predict more trade and economic integration than scholars observe. One branch of open economy macroeconomic research has tried to explain these anomalies through the use of dynamic macroeconomic models similar to those that have been employed to analyze domestic macroeconomic issues such as business cycles.

Some of these puzzles can be solved without resorting to the assumption of price stickiness. The home-bias problem can be partially explained by adding transaction costs. The cost adds a friction that prevents consumers and firms from fully optimizing. Models based on microeconomic foundations can often be constructed to enough precision so that they can be calibrated to empirical data and tested quantitatively.

Price anomalies such as the failure of purchasing power parity and the failure of the exchange rate to correlate systematically with other variables require more than just transaction costs to explain. Nominal price rigidity (or sticky prices) may also be necessary.

Research in the new open economy macroeconomics builds on previous work by incorporating price rigidities. The Mundell-Fleming model, like other models in the Keynesian tradition, assumed an extreme form of price rigidity: prices were assumed to be fixed. In the new open economy macroeconomics, prices are not fixed by assumption but are allowed to be somewhat fixed in the short run. Often, the mechanism by which the price rigidity occurs is based on microeconomic foundations. Imperfect competition and price discrimination are common features of such models. Menu costs and other mechanisms for allowing prices to update slowly ensure that the model does not go immediately to the long-run equilibrium. As a result, pricing anomalies arise endogenously; as a result, government intervention in currency and money markets may have real economic effects.

Unanswered Questions

Many unanswered questions remain, and many important recent economic phenomena present an ambitious agenda for open economy macroeconomic research. There is fundamental agreement among the many models that an economy cannot simultaneously achieve price stability, exchange rate stability, and perfect capital mobility—a situation known as the trilemma.

Until recently, China achieved the first two conditions by controlling capital flows. As the Chinese economy loosens the capital controls, China will lose its grip on either domestic prices (higher inflation) or the exchange rate (revaluation). What remains uncertain is the precise mechanism by which internal and external prices will be affected.

Other economies face decisions about whether to abandon fixed exchange rate regimes to regain control of their domestic money supply. Fixed exchange rates offer stability but are subject to speculative attack. Understanding the nature of nominal price rigidity in international markets is crucial to evaluating the various policy options available to governments. Researchers in open economy macroeconomics continue to grapple with these critical issues.

Bibliography:

Malin Adolfson, Stefan Laséen, Jesper Lindé, and Mattias Villani, Evaluating an Estimated New Keynesian Small Open Economy Model (Centre for Economic Policy Research, 2007);
Paul R. Bergin, “How Well Can the New Open Economy Macroeconomics Explain the Exchange Rate and Current Account?” Journal of International Money and Finance (v.25/5, 2006);
Giancarlo Corsetti, New Open Economy Macroeconomics (Centre for Economic Policy Research, 2007);
Rudiger Dornbusch, Stanley Fischer, and Richard Startz, Macroeconomics (McGraw-Hill Irwin, 2008);
Steven L. Husted and Michael Melvin, International Economics (Pearson Addison-Wesley, 2007);
Yongseung Jung, “Can the New Open Economy Macroeconomic Model Explain Exchange Rate Fluctuations?” Journal of International Economics (v.72/2, 2007);
Paul Krugman, The Return of Depression Economics (W. W. Norton, 2000);
C. Lim and Paul D. McNelis, Computational Macroeconomics for the Open Economy (MIT Press, 2008);
Maurice Obstfeld, Jay C. Shambaugh, and Alan M. Taylor, “The Trilemma in History: Tradeoffs Among Exchange Rates, Monetary Policies, and Capital Mobility,” The Review of Economics and Statistics (v.87/3, 2005);
Ozge Senay, “Interest Rate Rules and Welfare in Open Economies,” Scottish Journal of Political Economy (v.55/3, July 2008).

This example Open Economy Macroeconomics Essay is published for educational and informational purposes only. If you need a custom essay or research paper on this topic please use our writing services. EssayEmpire.com offers reliable custom essay writing services that can help you to receive high grades and impress your professors with the quality of each essay or research paper you hand in.