Towards paradigm - Economy, Study notes of Economics

Download Towards paradigm - Economy and more Study notes Economics in PDF only on Docsity! FEDERAL RESERVE BANK OF ST. LOUIS MAY/JUNE 2001 21 Toward a New Paradigm in Open Economy Modeling: Where Do We Stand? Lucio Sarno In the last few decades, there have been a num- ber of important developments, both theoreti- cal 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 macroeco- nomic 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 determina- tion in the context of dynamic general equilibrium models with explicit microfoundations, nominal rigidities, and imperfect competition.1 The main objective of this research program is to develop a new workhorse model for open econ- omy 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 microfoundations; they offer the ability to perform welfare analysis and rigor- ously 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 ana- lytical structure, which makes it easy to discuss in policy circles. Because the predictions of new open economy models are sensitive to the partic- ular specification of the microfoundations, policy evaluation and welfare analysis depend on the specification of preferences and nominal rigidi- ties. In turn, this generates a need for the profes- sion to agree on the “correct” or at least “prefer- able” specification of the microfoundations. The present paper reviews the key contribu- tions 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 para- digm for open economy modeling and describes the directions taken by the latest literature. The remainder of the paper is set out as fol- lows. The first section provides a review of the seminal paper in this literature, proposing the so- called redux model, while the second section cov- ers a number of variants and generalizations of the redux model that permit allowance for alter- native nominal rigidities, pricing to market, alter- native 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 sec- tion. Some new directions taken by the latest liter- ature 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 econo- my 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 Lucio Sarno is a reader in economics and finance at the Warwick Business School, University of Warwick, and a research affiliate of the Centre for Economic Policy Research, London. This paper was written in part while the author was a visiting scholar at the Federal Reserve Bank of St. Louis. The author thanks the United Kingdom Economic and Social Research Council (ESRC) for providing finan- cial support (grant No. L138251044) and Gaetano Antinolfi, James Bullard, Giancarlo Corsetti, Brian Doyle, Fabio Ghironi, Peter Ireland, Marcus Miller, Chris Neely, Michael Pakko, Neil Rankin, Mark Taylor, and Dan Thornton for constructive comments. Paige Skiba provided research assistance. The views expressed are those of the author and should not be interpreted as reflecting those of any institution. 1 An early draft of this paper covered some of the models discussed below in a more technical fashion. The preliminary technical ver- sion is available from the author upon request (Sarno, 2000). Walsh (1998) also provides an excellent treatment of the redux model, especially focusing on monetary issues. See also the comprehensive textbook treatment of the early new open economy literature by OR (1996) and its selective coverage by Lane (1999). For a treatment of the role of imperfect competition in macroeconomic models, see the survey by Dixon and Rankin (1994). 22 MAY/JUNE 2001 R E V I E W and van Wijnbergen (1989). They present a stochas- tic, 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 interna- tional 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. It is also fair to say that the need for rigorous microfoundations in open economy models is not novel in new open economy macroeconomics and has been empha- sized by several papers prior to OR (1995); notable examples are Lucas (1982), Stockman (1980, 1987), and Backus, Kehoe, and Kydland (1992, 1994, 1995), among others. The baseline model proposed by OR (1995) is a two-country, dynamic general equilibrium model with microfoundations that allows for nominal price rigidities, imperfect competition, and a con- tinuum of agents who both produce and con- sume. Each agent produces a single differentiated good. All agents have identical preferences, char- acterized by an intertemporal utility function that depends positively on consumption and real money balances but negatively on work effort; effort is positively related to output. The exchange rate is defined as the domestic price of the foreign currency. The two countries are called Home and Foreign, respectively. Because the model assumes no impediments to international trade, the law of one price (LOOP) holds for each individual good and purchasing power parity (PPP) holds for the internationally identical aggregate consumption basket. PPP is the proposition that national price levels should be equal when expressed in a common currency; the LOOP is the same proposition applied to individu- al goods rather than a consumption basket. Since the real exchange rate is the nominal exchange rate adjusted for relative national price levels, vari- ations in the real exchange rate represent devia- tions from PPP. Hence, the LOOP and continuous PPP imply a constant real exchange rate, while long-run PPP (where temporary deviations from PPP are allowed for) implies mean reversion in the real exchange rate. OR also assume that both countries can bor- row and lend in an integrated world capital mar- ket. The only internationally traded asset is a risk- less real bond, denominated in the consumption good. Agents maximize lifetime utility subject to their budget constraints (identical for domestic and foreign agents). Utility maximization then implies three clearly interpretable conditions. The first is the standard Euler equation, which implies a flat time path of consumption over time. The second condition is the money market equilibrium condition that equates the marginal rate of substi- tution of consumption for the services of real money balances to the consumption opportunity cost of holding real money balances (the nominal interest rate); the representative agent directly bene- fits from holding money in the utility function but loses the interest rate on the riskless bond as well as the opportunity to eliminate the cost of inflation. (Note that money demand depends on consumption rather than income in this model.) The third condition requires that the marginal util- ity of the higher revenue earned from producing one extra unit of output equals the marginal dis- utility of the needed effort, and so can be inter- preted as a labor-leisure trade-off equation. In the special case when net foreign assets are zero and government spending levels are equal across countries, OR solve the model for income and real money balances. Because this model is based on a market structure with imperfect com- petition where each agent has some degree of market power arising from product differentia- tion, the solutions of the model imply that steady- state output is suboptimally low. As the elasticity of demand (say q ) increases, the various goods become closer substitutes and, consequently, the monopoly power decreases. As q approaches infinity, output increases, tending to the level cor- responding to a perfectly competitive market. The main focus of OR (1995) is the impact of a monetary shock on real money balances and output. Under perfectly flexible prices, a perma- nent shock produces no dynamics and the world economy remains in steady state (prices increase by the same proportion as the money supply). That is, an increase in the money supply has no real effects and cannot remedy the suboptimal output level. Money is neutral.2 2 Note that in the redux model and in a number of subsequent papers, monetary shocks are discussed without a formalization of the reaction functions of the monetary authorities. However, some recent studies have formally investigated reaction functions in new open economy macroeconomic models; see, for example, Ghironi and Rebucci (2000) and the references therein. FEDERAL RESERVE BANK OF ST. LOUIS MAY/JUNE 2001 25 tic producer prices. In some sense, the results of the redux analysis are confirmed in the context of a market structure with factor price rigidities. How- ever, nontradables modify the transmission mech- anism in important ways. A larger nontradables share implies that exchange rate movements are magnified, since the money market equilibrium relies on a short-run price adjustment carried out by fewer tradables. This effect is interesting since it may help explain the observed high volatility of the nominal exchange rate relative to price volatility. Within the framework of price level rigidities, however, a more sophisticated way of capturing price stickiness is through staggered price setting that allows smooth, rather than discrete, aggregate price level adjustment. Staggering price models of the type developed by, among others, Taylor (1980) and Calvo (1983) are classic examples. Kollmann (1997) calibrates a dynamic open economy model with both sticky prices and sticky wages and then explores the behavior of exchange rates and prices in response to monetary shocks with predetermined price and wage setting and Calvo-type nominal rigidities. His results suggest that Calvo-type nomi- nal rigidities match very well the observed high correlation between nominal and real exchange rates and the smooth adjustment in the price level, but they match less well correlations between out- put and several other macroeconomic variables. Chari, Kehoe, and McGrattan (CKM) (1998, 2000) link sticky price models to the behavior of the real exchange rate in the context of a new open economy macroeconomic model. They start by noting that the data show large and persistent devi- ations of real exchange rates from PPP that appear to be driven primarily by deviations from the LOOP for tradable goods. That is, real and nominal exchange rates are about six times more volatile than relative price levels and both are highly persis- tent, with first-order serial correlations of about 0.85 and 0.83, respectively, at annual frequency. CKM then develop a sticky price model with price- discriminating monopolists that produces devia- tions from the LOOP for tradable goods. However, their benchmark model, which has prices set for one quarter at a time and a unit consumption elas- ticity of money demand, does not come close to reproducing the serial correlation properties of real and nominal exchange rates noted above. A model in which producers set prices for six quarters at a time and with a consumption elasticity of money demand of 0.27 does much better in generating persistent and volatile real and nominal exchange rates. The serial correlations of real and nominal exchange rates are 0.65 and 0.66, respectively, and exchange rates are about three times more volatile than relative price levels. In a closely related paper, Jeanne (1998) attempts to assess whether money can generate persistent economic fluctuations in a dynamic general equilibrium model of the business cycle. Jeanne shows that a small nominal friction in the goods market can make the response of output to monetary shocks large and persistent if it is ampli- fied by real-wage rigidity in the labor market. He also argues that, for plausible levels of real-wage rigidity, a small degree of nominal stickiness may be sufficient for money to produce economic fluctua- tions as persistent as those observed in the data.6 OR (2000a), discussed in detail later in this paper, develop a stochastic new open economy macroeconomic model based on sticky nominal wages, monopolistic competition, and exporters- currency pricing. Solving explicitly the wage-setting problem under uncertainty allows the analysis of the welfare implications of alternative monetary regimes and their impact on expected output and terms of trade. To motivate their model, OR show that observed correlations between terms of trade and exchange rates appear to be more consistent with their assumptions about nominal rigidities than with the alternative specification based on local-currency pricing. I now turn to a discussion of the reformulations of the redux model based on the introduction of pricing to market. Pricing to Market While the redux model assumes that the LOOP holds for all tradable goods, a number of re- searchers have questioned the model on the ground that deviations from the LOOP across inter- national borders appear to be larger than can be explained by geographical distance or transport costs (see, for example, Engel, 1993, and Engel and Rogers, 1996). Some authors have therefore ex- tended the redux model by combining internation- al segmentation with imperfectly competitive firms and local-currency pricing (essentially pric- ing to market or PTM). Krugman (1987) used the term PTM to characterize price discrimination for 6 See also Andersen (1998), Benigno (1999), and Bergin and Feenstra (1999, 2000). 26 MAY/JUNE 2001 R E V I E W certain types of goods (such as automobiles and many types of electronics) where international ar- bitrage is difficult or perhaps impossible. This may be due, for example, to differing national standards (for example, 100-volt light bulbs are not used in Europe and left-hand-side-drive cars are not popu- lar in the United Kingdom, Australia, or Japan). Further, monopolistic firms may be able to limit or prevent international goods arbitrage by refusing to provide warranty service in one country for goods purchased in another. To the extent that prices cannot be arbitraged, producers can dis- criminate across different international markets. Studies allowing for PTM typically find that PTM may play a central role in exchange rate de- termination and in international macroeconomic fluctuations. This happens because PTM acts to limit the pass-through from exchange rate move- ments to prices, reducing the “expenditure switch- ing” role of exchange rate changes and potentially generating greater exchange rate variability than would be obtained in models without PTM. Also, nominal price stickiness, in conjunction with PTM, magnifies the response of the exchange rate to macroeconomic fundamentals shocks. Further, by generating deviations from PPP, PTM models also tend to reduce the comovement in consumption across countries while increasing the comovement of output, fitting some well-known empirical regu- larities (see Backus, Kehoe, and Kydland, 1992). Finally, the introduction of PTM has important wel- fare implications for the international transmission of monetary policy shocks, as discussed below. Betts and Devereux (2000b), for example, char- acterize PTM by assuming that prices of many goods are set in the local currency of the buyer and do not adjust at high frequency. Consequently, real exchange rates move with nominal exchange rates at high frequency. These assumptions also imply that price/cost markups fluctuate endoge- nously in response to exchange rate movements rather than nominal prices (see also Knetter, 1993, on this point). In the Betts-Devereux framework, traded goods are characterized by a significant de- gree of national market segmentation and trade is carried out only by firms. Households cannot arbi- trage away price differences across countries, and firms engage in short-term nominal price setting. Therefore, prices are sticky in terms of the local currency.7 The Betts-Devereux model is based on an economy with differentiated products and assumes that firms can price-discriminate across countries. With a high degree of PTM (that is, when a large fraction of firms engages in PTM), a depreciation of the exchange rate has little effect on the relative price of imported goods faced by domestic con- sumers. This weakens the allocative effects of ex- change rate changes relative to a situation where prices are set in the seller’s currency; in the latter case, pass-through of exchange rates to prices is immediate. Hence, PTM reduces the expenditure switching effects of exchange rate depreciation, which generally implies a shift of world demand toward the exports of the country whose currency is depreciating. Because domestic prices show lit- tle response to exchange rate depreciation under PTM, the response of the equilibrium exchange rate may be substantially magnified and, consis- tent with well-known observed empirical regulari- ties, exchange rates may vary more than relative prices. PTM also has implications for the international transmission of macroeconomic shocks. In the ab- sence of PTM, for example, monetary disturbances tend to generate large positive comovements of consumption across countries but large negative comovements of output. However, PTM reverses the ordering: the deviations from PPP induced by PTM make consumption comovements fall. At the same time, the elimination of expenditure switch- ing effects of the exchange rate enhances comove- ments of output across countries. In terms of welfare, recall that the framework based on the LOOP and PPP generally suggests that an unanticipated monetary expansion raises welfare of all agents at home and abroad. With PTM, however, a domestic monetary expansion raises home welfare but reduces foreign welfare and monetary policy is a “beggar-thy-neighbor” instrument. Therefore, the PTM framework, un- like the framework based on the LOOP and PPP, provides a case for international monetary policy coordination. Overall, the PTM framework suggests that goods market segmentation might help explain in- ternational quantity and price fluctuations and may have important implications for the interna- tional transmission of economic shocks, policy, and welfare. 7 The model of Betts and Devereux (2000b) is used as a representa- tive of this class of PTM models in this section. Other examples of models adopting PTM are Betts and Devereux (1996, 1997, 1999, 2000a); CKM (1998, 2000); and Bergin and Feenstra (1999, 2000). FEDERAL RESERVE BANK OF ST. LOUIS MAY/JUNE 2001 27 The Indeterminacy of the Steady State In the framework proposed by OR (1995), the current account plays a crucial role in the trans- mission of shocks. However, the steady state is in- determinate and both the consumption differential between countries and an economy’s net foreign assets are nonstationary. After a monetary shock, the economy will move to a different steady state until a new shock occurs. When the model is log- linearized to obtain closed-form solutions of the endogenous variables, one is approximating the dynamics of the model around a moving steady state. This makes the conclusions implied by the model questionable. In particular, the reliability of the log-linear approximations is low because vari- ables wander away from the initial steady state. Many subsequent variants of the redux model de-emphasize the role of net foreign assets accu- mulation as a channel of macroeconomic inter- dependence between countries. This is done by assuming that (i) the elasticity of substitution between domestic and foreign goods is unity or (ii) financial markets are complete. Both of these assumptions imply that the current account does not react to shocks (see, for example, Corsetti and Pesenti, 2001, and OR, 2000a).8 While this frame- work achieves the desired result of determinacy of the steady state, it requires strong assumptions— (i) or (ii) above—to shut off the current account, which is unrealistic. In a sense these solutions cir- cumvent the problem of indeterminacy, but they do not solve it. Ghironi (2000a) provides an extensive discus- sion of the indeterminacy and nonstationarity problems in the redux model. Ghironi also pro- vides a tractable two-country model of macro- economic interdependence that does not rely on either of the above assumptions in that the elasticity of substitution between domestic and foreign goods can be different from unity and that finan- cial markets are incomplete, consistent with reali- ty. Using an overlapping generations structure, Ghironi shows how there exists a steady state, en- dogenously determined, to which the world econ- omy reverts following temporary shocks. Accumu- lation of net foreign assets plays a role in the transmission of shocks to productivity. Finally, Ghironi also shows that shutting off the current account may lead to large errors in welfare com- parisons, which calls for rethinking of several re- sults in this literature. The issue of indeterminacy of the steady state deserves further attention from researchers in this area. Preferences While the explicit treatment of microfounda- tions is a key advantage of new open economy macroeconomic models relative to the MFD model, the implications of such models depend on the specification of preferences. One convenient as- sumption in the redux model is the symmetry with which home and foreign goods enter preferences in the constant-elasticity-of-substitution (CES) utili- ty function. Corsetti and Pesenti (2001) extend the redux model to investigate the effects of a limited degree of substitution between home and foreign goods. In their baseline model, the LOOP still holds and technology is described by a Cobb-Douglas production function, with a unit elasticity of sub- stitution between home and foreign goods and constant income shares for home and foreign agents. The model illustrates that the welfare ef- fects of expansionary monetary and fiscal policies are related to internal and external sources of eco- nomic distortion, namely, monopolistic supply in production and monopoly power of a country. For example, an unanticipated exchange rate deprecia- tion can be “beggar-thyself” rather than “beggar- thy-neighbor” since gains in domestic output are offset by losses in consumers’ purchasing power and a deterioration in terms of trade. Also, open- ness is not inconsequential: smaller and more open economies are more prone to inflationary conse- quences. Fiscal shocks, however, are generally “beggar-thy-neighbor” in the long run, but they raise domestic demand in the short run for given terms of trade. These results provide a role for in- ternational policy coordination, which is not the case in the redux model.9,10 An important assumption in the redux model is that consumption and leisure are separable. This 8 This is a problem often encountered in the international real busi- ness cycles literature. Note, however, that the role of current account dynamics in generating persistent effects of transitory shocks has often been found to be quantitatively unimportant in this literature. See the discussion on this point by Baxter and Crucini (1995) and Kollmann (1996). 9 Recall that the redux model has the unrealistic implication that the optimal monetary surprise is infinite, which is of course not the case in the Corsetti-Pesenti model. 10 Devereux (1999), Doyle (2000), Tille (1998a, b), Betts and Devereux (2000a), and Benigno (2001), among others, represent attempts to model explicitly international policy coordination in variants of the Corsetti-Pesenti model. See also OR (2000b). 30 MAY/JUNE 2001 R E V I E W level of the exchange rate risk premium and a fall in the forward premium (the latter fall is shown to be much larger in magnitude). This result contra- dicts the conventional wisdom that financial mar- kets attach a positive risk premium to the currency with higher monetary volatility. The intuition is explained by OR (1998) as follows: [A] rise in Home monetary volatility may lead to a fall in the forward premium, even holding expected exchange rate changes constant. Why? If positive domestic mone- tary shocks lead to increases in global con- sumption, then domestic money can be a hedge, in real terms, against shocks to con- sumption. (The real value of Home money will tend to be unexpectedly high in states of nature where the marginal utility of consumption is high.) Furthermore—and this effect also operates in a flexible-price model—higher monetary variability raises the expectation of the future real value of money, other things equal. (p. 24) This result provides a novel theoretical expla- nation of the forward premium puzzle. Not only should high interest rates not necessarily be asso- ciated with expected depreciation, but the oppo- site may also be true, especially for countries with similar trend inflation rates. Nevertheless, the results produced by this model may well depend critically on the specifi- cation of the microfoundations and are, therefore, subject to the same caveats raised by the literature questioning the appropriateness of the redux specification. Thus, it is legitimate to wonder how adopting the other specifications (alternative specifications of utility, different nominal rigidi- ties, etc.) described earlier would affect the results of the OR (1998) stochastic model. The next sub- section discusses, for example, the changes induced by the introduction of PTM in this model. Related Studies The OR (1998) analysis described above is based on the following assumptions: (i) that pro- ducers set prices in their own currency, (ii) that the price paid by foreigners for home goods (and the price paid by domestic residents for foreign goods) varies instantaneously when the exchange rate changes, and (iii) that the LOOP holds. Devereux and Engel (1998) extend the OR (1998) analysis by assuming PTM and that producers set a price in the home currency for domestic residents and in the foreign currency for foreign residents. Hence, when the exchange rate fluctuates, the LOOP does not hold. The risk premium depends on the type of price-setting behavior of producers. Devereux and Engel compare the agent’s welfare between fixed and flexible exchange rate arrangements and find that exchange rate systems matter not only for the variances of consumption, real balances, and leisure but also for their mean values once risk premia are incorporated into pricing decisions. Since PTM insulates consumption from exchange rate fluctuations, floating exchange rates are less costly under PTM than under producer currency pricing. Consequently, a flexible regime generally dominates a pegged regime.15 Engel (1999) makes four points in summariz- ing the evidence on the foreign exchange risk pre- mium in this class of general equilibrium models. First, while the existence of a risk premium in flexible-price general equilibrium models depends on the correlation of exogenous monetary shocks and aggregate supply shocks, the risk premium arises endogenously in sticky-price models. Second, the distribution of aggregate supply shocks does not affect the foreign exchange risk premium in sticky-price models. Third, given that the risk pre- mium depends on the prices faced by consumers, when the LOOP does not hold there is no unique foreign exchange risk premium since producers set prices in consumers’ currencies. Fourth, stan- dard stochastic dynamic general equilibrium models do not usually imply large risk premia. The common denominator in these models is that the exchange rate risk premium is an impor- tant determinant of the equilibrium level of the exchange rate. It remains an open question whether one could build a sticky-price model capable of convincingly explaining the forward premium puzzle. Nevertheless, this seems a promising avenue for future research. NEW DIRECTIONS: THE SOURCE OF NOMINAL RIGIDITIES AND THE CHOICE BETWEEN LOCAL AND FOREIGN CURRENCY PRICING OR (2000a) may have again set new directions for stochastic open economy models of the class 15 See also Bacchetta and van Wincoop (1998). FEDERAL RESERVE BANK OF ST. LOUIS MAY/JUNE 2001 31 discussed in this paper. They start by noting that the possibilities for modeling nominal rigidities are more numerous in a multicurrency interna- tional economy than in a single-money closed economy setting and that, in an international set- ting, it is natural to consider the possibility of seg- mentation between national markets. OR address the empirical issue of whether local currency pric- ing or foreign currency pricing is closer to reality. OR argue that, if imports are invoiced in the im- porting country’s currency, unexpected currency depreciations should be associated with improve- ments (rather than deteriorations) in the terms of trade. They then show that this implication is incon- sistent with the data. Indeed, their evidence sug- gests that aggregate data may favor a traditional framework in which exporters largely invoice in home currency and nominal exchange rate changes have significant short-run effects on international competitiveness and trade. The main reservations of OR about the PTM– local currency pricing framework employed by several papers in this literature are captured by the following observations. First, a large fraction of measured deviations from the LOOP results from nontradable components incorporated in con- sumer price indices for supposedly traded goods (for example, rents, distribution services, advertis- ing, etc.); it is not clear whether the extreme mar- ket segmentation and pass-through assumptions of the PTM–local currency pricing approach are nec- essary to explain the close association between deviations from the LOOP and exchange rates. Sec- ond, price stickiness induced by wage stickiness is likely to be more important in determining persis- tent macroeconomic fluctuations since trade invoic- ing cannot generate sufficiently high persistence. (Invoicing largely applies to contracts of 90 days or less.) Third, the direct evidence on invoicing is largely inconsistent with the view that exporters set prices mainly in importers’ currencies (see, for example, ECU Institute, 1995); the United States is, however, an exception. Fourth, international evi- dence on markups is consistent with the view that invoicing in exporters’ currencies is the pre- dominant practice (see, for example, Goldberg and Knetter, 1997). OR (2000a) build their stochastic dynamic open economy model with nominal rigidities in the labor market (rationalized on the basis of the first two observations above) and foreign currency pricing (rationalized on the basis of the last two observations above). They consider a standard two- country global economy where Home and Foreign produce an array of differentiated tradable goods (Home and Foreign have equal size). In addition, each country produces an array of differentiated nontraded goods. Workers set next period’s domestic-currency nominal wages and then meet labor demand in the light of realized economic shocks. Prices of all goods are completely flexible. OR provide equilibrium equations for preset wages and a closed-form solution for each endoge- nous variable in the model as well as solutions for variances and for utility. In particular, the solu- tion for the exchange rate indicates that a relative Home money supply increase that occurs after nominal wages are set would cause an overshoot- ing depreciation in the exchange rate. A fully anticipated change, however, causes a precisely equal movement in the wage differential and in the exchange rate. In this setup, OR show welfare results on two fronts. First, they show that constrained-efficient monetary policy rules replicate the flexible-price equilibrium and feature a procyclical response to productivity shocks.16 For example, a positive pro- ductivity shock that would elicit greater labor sup- ply and output under flexible wages optimally induces an expansionary Home monetary response when wages are set in advance. The same shock elicits a contractionary Foreign monetary response, but the net global monetary response is always positive. Also, optimal monetary policy allows the exchange rate to fluctuate in response to cross- country differences in productivity shocks. This conclusion is similar to the result obtained by King and Wolman (1996) in a rational expectations model where monetary policy has real effects because imperfectly competitive firms are con- strained to adjust prices only infrequently and to satisfy all demand at posted prices. In the King- Wolman sticky-price model, it is optimal to set monetary policy so that the nominal interest rate is close to zero (that is, neutralizing the effect of the sticky prices), replicating in an imperfectly competitive model the result that Friedman found under perfect competition. Under a perfect infla- 16 These monetary policy rules are (i) constrained since they are derived by maximizing an average of Home and Foreign expected utilities subject to the optimal wage-setting behavior of workers and price-setting behavior of firms described in the model, and (ii) effi- cient since the market allocation cannot be altered without making one country worse off, given the constraints. 32 MAY/JUNE 2001 R E V I E W tion target, the monetary authority makes the money supply evolve so that a model with sticky prices behaves much like one with flexible prices. Second, OR calculate the expected utility for each of three alternative monetary regimes, namely, an optimal floating rate regime, world monetarism (under which two countries fix the exchange rate while also fixing an exchange rate– weighted average of the two national money sup- plies), and an optimal fixed rate regime. The out- come is that the expected utility under an optimal floating-rate regime is highest. This result is intu- itively obvious given that optimal monetary policy in this model involves allowing the exchange rate to fluctuate in response to cross-country differ- ences in productivity shocks. Fixed-rate regimes would only be worthwhile if productivity shocks at home and abroad were perfectly correlated.17 The OR (2000a) model addresses several theo- retical and policy questions, including welfare analysis under alternative nominal regimes. The assumption that nominal exchange rate move- ments shift world demand between countries in the short run, which plays a crucial role in the traditional MFD model, is shown to be consistent with the facts and can reasonably be used as a building block in stochastic open economy mod- els. Needless to say, this approach warrants fur- ther generalizations and refinements. In particu- lar, note that the current account is shut off in OR (2000a) to avoid the indeterminacy problem dis- cussed earlier. However, shutting off the current account makes the model less plausible from an empirical point of view since it distorts the dynamics of the economy being modeled. It is worth noting that the new open economy macroeconomics literature to date has (implicitly or explicitly) assumed that there are no costs of international trade. Nevertheless, the introduction of some sort of international trade costs (includ- ing, among others, transport costs, tariffs, and nontariff barriers) may be key in understanding how to improve empirical exchange rate models and in explaining several unresolved puzzles in international macroeconomics and finance. While the allowance of trade costs in open economy modeling is not a new idea and goes back at least to Samuelson (1954), OR (2000c) have recently stressed the role of trade costs in open economy macroeconomics. Indeed, OR (2000c) present something of a “unified theory” that helps eluci- date what the profession may be missing when trying to explain several puzzling empirical find- ings using trade costs as the fundamental model- ing feature, with sticky prices playing a distinctly secondary role. It is hoped that future research in new open economy macroeconomics follows the suggestion of OR (2000c) to make explicit allow- ance for non-zero international trade costs. CONCLUSIONS In this paper, I have selectively reviewed the recent literature on new open economy macro- economics, which has been growing exponentially in the last five years or so. The increasing sophis- tication of stochastic open economy models allows rigorous welfare analysis and provides new expla- nations of several puzzles in international macro- economics and finance. Whether this approach will become the new workhorse model for open economy macroeconomics, whether a preferred specification within this class of models will be reached, and whether this approach will provide insights on developing better-fitting empirical exchange rate models are open questions. Although the theory in the spirit of new open economy macroeconomics is developing very rapidly, there is little effort at present to test the predictions of new open economy models. Theorists working in this area should specify exactly which empirical exchange-rate equations they would have empiricists estimate. If there is to be consensus in the profession on a particular model specification, this theoretical apparatus has to produce clear estimable equations.18 Agreeing on a particular new open economy model is hardly possible at this stage. This is the case not least because it requires agreeing on assumptions which are often difficult to test directly (such as the specification of the utility function) or because they concern issues on which economists have strong beliefs on which they have not often been willing to compromise (such as whether nominal rigidities originate from the goods market or the labor market or whether 17 Indeed, the results suggest that the difference between the expected utility under an optimal floating-rate regime and the expected utili- ty under an optimal fixed-rate regime may not be too large if the variance of productivity shocks is very small or the elasticity of util- ity with respect to effort is very large. 18 A first step toward new open economy macroeconometrics has been made, for example, by Ghironi (2000c). I am also currently investigating empirical exchange rate equations inspired by the new open economy macroeconomics literature. FEDERAL RESERVE BANK OF ST. 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