The new open economy macroeconomics: a survey

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Journal of International Economics 54 (2001) 235–266 / locate / econbase
The new open economy macroeconomics: a survey
Philip R. Lane
Economics Department, Trinity College Dublin and CEPR, Dublin 2, Ireland
Received 28 July 1999; accepted 20 December 1999
Since the 1995 publication of Obsteld and Rogoff’s Redux model, there has been an
outpouring of research on open-economy dynamic general equilibrium models that
incorporate imperfect competition and nominal rigidities. This paper offers an interim
survey of this recent literature.
© 2001 Elsevier Science B.V. All rights reserved.
Keywords: New open economy macroeconomics; Nominal rigidities; Imperfect competition
JEL classification: F3; F4
1. Introduction
This article surveys some recent efforts to develop a new workhorse model for
open-economy macroeconomic analysis. The unifying feature of this emerging
literature is the introduction of nominal rigidities and market imperfections into a
dynamic general equilibrium model with well-specified microfoundations.
Imperfect competition – whether in product or factor markets – is a key
ingredient in the new models. One reason is that, in contrast to perfect competition
(under which agents are price-takers), monopoly power permits the explicit
analysis of pricing decisions. Second, equilibrium prices set above marginal cost
rationalize demand-determined output in the short run, since firms are not losing
*Tel.: 1353-1-608-2259; fax: 1353-1-677-2503.
E-mail address: [email protected] (P.R. Lane).
1For electronic links to many of the papers cited in this survey, see the New Open Economy
Macroeconomics internet site maintained by Brian Doyle: http: / / / |bmdoyle /
0022-1996 / 01 / $ – see front matter
© 2001 Elsevier Science B.V. All rights reserved.
P I I : S 0 0 2 2 - 1 9 9 6 ( 0 0 ) 0 0 0 7 3 - 8

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
money on the additional production. Third, monopoly power means that equilib-
rium production falls below the social optimum, which is a distortion that can
potentially be corrected by activist monetary policy intervention.
This approach offers several attractions. The presentation of explicit utility and
profit maximization problems provides welcome clarity and analytical rigor.
Moreover, it allows the researcher to conduct welfare analysis, thereby laying the
groundwork for credible policy evaluation. Allowing for nominal rigidities and
market imperfections alters the transmission mechanism for shocks and also
provides a more potent role for monetary policy. In this way, by addressing issues
of concern to policymakers, one goal of this new strand of research is to provide
an analytical framework that is relevant for policy analysis and offers a superior
alternative to the Mundell–Fleming model that is still widely employed in policy
circles as a theoretical reference point.
In describing the findings of this research program, I focus almost exclusively
on the analysis of monetary shocks. This reflects the emphasis in the literature, for
the role of nominal rigidities is most starkly illustrated in the case of monetary
shocks and it is this kind of disturbance that flexible-price models are least
well-equipped to handle.
Obstfeld and Rogoff (1995a) is commonly recognized as the contribution that
launched this new wave of research and this paper is reviewed in Section 2 below.
An important precursor was the paper by Svensson and van Wijnbergen (1989).
This paper is a manifesto for sticky-price models that have solid microfoundations
and are firmly embedded in an intertemporal setting and much of the analytic
structure of that paper has been adopted in the more recent literature. However,
these authors modelled home and foreign outputs as stochastic endowments and
the subsequent literature has devoted much more attention to endogenizing the
production side of the economy. Krugman (1995) also signalled many of the
research issues which have received attention in this new literature.
Finally, it should be noted that the research program described here is very
much linked to developments in closed-economy macroeconomics. There is a
sense that macroeconomists are converging on a common modelling framework
that integrates imperfect competition and nominal rigidities into dynamic general
equilibrium models. This recent development has been labelled ‘neomonetarism’
by Kimball (1995) and the ‘new neoclassical synthesis’ by Goodfriend and King
The rest of the paper is organized as follows. The Obstfeld–Rogoff Redux
model is briefly outlined in Section 2. Section 3 reviews alternative approaches to
modelling nominal rigidity. The impact of market segmentation and pricing to
market behavior is discussed in Section 4. We turn to the specification of
preferences and technology in Section 5. Section 6 introduces variation in financial
2As is discussed below, this is only true if the shock is not so large as to drive marginal costs above
marginal revenues.

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
structure. The analysis of international policy interdependence is reviewed in
Section 7. Section 8 discusses theoretical frameworks that explicitly allow for
uncertainty and Section 9 alternative approaches to modelling market structure.
Small open economy models are the subject of Section 10. Section 11 reviews the
body of empirical work associated with this new research program. Section 12
2. Exchange rate dynamics redux
As was noted in the Introduction, Obstfeld and Rogoff (1995a) effectively
initiated this new research program. In this section, we briefly outline the main
features of their Redux model. They set up a two-country model. Each country is
populated by a continuum of yeoman-farmers (consumer-producers) that produce
differentiated goods ([0, n] live in the home country; (n, 1] in the foreign country).
Preferences for individual j in the home country are given by
s 2t
s 21 /s
U 5O b
]] C
1 ]]
2 ] y (z)
s 2 1
1 2 ´
where s, ´ . 0, m . 1, 0 , b , 1 and C is a CES index aggregating across the
differentiated varieties of the consumption good
u /u 21
u 21 /u
C 5 E c(z)
u . 1
where u is the elasticity of substitution between varieties. Goods [0, n] are
produced domestically and (n, 1] overseas: home and foreign goods enter
symmetrically into preferences. The corresponding price index is
1 / 12u
P 5 E p(z)
M /P are the real balances held in period t and the last term in (1) captures the
disutility of work effort. There is no capital in the model. It follows from (2) that
each consumer-producer faces the constant-elasticity demand curve for his output
y(z) 5 ]
F ]G C
where C is aggregate global consumption. Money is introduced into the economy
3The working paper version was released in April 1994 as NBER working paper no. 4693.
4Analagous equations hold for the representative individual in the foreign country.

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
by the government. Assuming zero government consumption, the revenue earned
from money creation is returned in the form of transfers (T , 0)
M 2 M
t 21
0 5 T 1 ]]]
Agents have access to an international riskless real bond market at the constant
interest rate r. The dynamic budget constraint is given by
P B 1 M 5 P (1 1 r)B
1 M
1 p (z)y (z) 2 P C 2 P T
t 21
t 21
where B is agent j’s bond holding entering period t 1 1.
Home and foreign individuals are assumed to have identical preferences and
there are no barriers to trade such that the law of one price holds for each good.
These assumptions mean that purchasing power parity holds and the consumption-
based real exchange rate is constant.
Each agent must decide her optimal choices of consumption, money holding,
labor supply and set her optimal output price. Prices are assumed to be set one
period in advance, introducing a nominal rigidity into the model. The solution
technique is to first solve for a steady state of the model. To study the dynamic
effects of a monetary shock, a log-linear approximation is taken around this steady
state. Since prices are sticky for one period, the solution distinguishes between the
impact (first-period) effect of a shock and its long-run steady-state effect.
Accordingly, the welfare effect of a shock is calculated as the sum of the short-run
change in utility and the discounted present value of the change in steady-state
The authors consider the Dornbusch experiment of a unanticipated permanent
increase in the domestic money supply. The impact effect of the monetary shock is
an increase in the level of domestic output and consumption. The world real
interest rate falls and nominal depreciation translates into a decline in the domestic
terms of trade: both factors generate an increase in foreign consumption. The
impact on foreign output is ambiguous, since the increase in aggregate consump-
tion and the relative price shift work in opposite directions. The domestic current
account moves into surplus.
In this case, money is not neutral in the long run. The short-run domestic current
account surplus implies a permanent improvement in domestic net foreign assets.
In the steady state, this implies a permanent domestic trade deficit since a positive
net investment income inflow allows consumption to remain permanently above
domestic output. The wealth effect of the positive net foreign asset position
reduces domestic labor supply (leisure is a normal good) and domestic output,
thereby generating a permanent improvement in the home country’s terms of trade.
An interesting result is that exchange rate overshooting is not possible in this
model. To see this, it is useful to present the equations for PPP, consumption
growth and short-run and long-run monetary equilibrium

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
E 5 P 2 P *;
E 5 P 2 P *
C 2 C * 5 C 2 C *
(M 2 M *) 2 E 5 C 2 C *
(M 2 M *) 2 E 5 C 2 C *
where ‘|’ denotes short-run values and ‘ 2 ’ denotes long-run values, respectively.
In Eq. (7), PPP implies that changes in the nominal exchange rate just match
inflation differentials. Eq. (8) combines the home and foreign consumption Euler
equations: since PPP holds, domestic and foreign agents face the same real interest
rate and domestic and foreign consumption growth rates are thereby identical. This
enables us to write the short-run and long-run monetary equilibrium conditions as
in Eqs. (9) and (10). By inspection of Eqs. (7)–(10), it follows that, since the
change in the money stock is permanent, the short-run change in relative domestic
real balances must equal the long-run change and so the permanent increase in the
nominal exchange rate just equals its initial jump (E 5 E ).
Finally, the monetary shock’s impact on home and foreign welfare can be
calculated. In evaluating welfare, the disparate effects of the money shock on
short-run and long-run values of consumption, real balances and leisure must be
aggregated according to the weights implied by the utility function (1). Re-
markably, it turns out that home and foreign welfare are raised by the same
amount, despite the asymmetric output effects of the shock. The intuition for this
result is that the first-order effect of the monetary shock is the initial general
increase in world demand. Since the imperfect competition distortion means that
the initial level of output was too low, a demand-driven increase in world output
raises welfare, to the equal benefit of both countries. The expenditure-switching
and terms of trade effects of the shock are only of second-order importance, since
optimizing agents would have initially set the marginal utility of extra revenue
equal to the marginal disutility of extra work effort. So the fact that home agents
produce more does not raise their relative utility level: the extra revenue is exactly
cancelled out by the increase in work effort. In similar fashion, current-account
imbalances have only second-order effects, since the initial equilibrium leaves
unexploited any marginal gains from reallocating consumption and leisure across
time periods.
This example vividly demonstrates the benefits of using a microfounded model.
In assessing the net impact of a shock that has myriad effects, some metric is
5This statement ignores a minor extra gain to domestic agents from a permanent increase in real
6The mechanism is exactly the aggregate demand externality highlighted by Blanchard and Kiyotaki

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
required and the representative agent’s utility function is the obvious choice in
evaluating welfare. The surprising result that both countries gain equally from an
unexpected domestic monetary expansion illustrates the utility-based evaluation
offers a non-trivial advantage over traditional ad-hoc loss functions.
Many of the assumptions in the Redux model have been modified in subsequent
work. In the following sections, we discuss the impact of these revisions to the
basic framework. We will show that the international transmission and welfare
effects of monetary shocks prove to be quite sensitive to the precise specification
of price stickiness, preferences and financial structure, to name just a subset of
relevant factors.
3. Nominal rigidities
The literature typically introduces nominal rigidity as an exogenous feature of
the environment. In the Redux model, firms simultaneously set prices one period
in advance. This assumption is arbitrary but convenient, since all adjustment is
completed after just one period. Clearly, if price stickiness is motivated by an
underlying fixed menu cost, firms will be motivated to immediately adjust prices
in the event of a large enough shock. Indeed, as Corsetti and Pesenti (1997)
emphasize, a sufficiently large shock would violate firms’ participation cost by
raising marginal cost above price. As such, the analysis should be interpreted as
applying only to the relevant range of shocks. That said, if we think of monetary
shocks as emanating from policy decisions, policymakers would take this
constraint into account when deciding the size of the stimulus to unleash on the
economy. Finally, nominal rigidity is invariably modelled in this literature as of
the time-dependent variety, since state-dependent pricing is not easily incorporated
into general equilibrium models.
3.1. Sticky wages
The literature has largely emphasized price stickiness as the locus of nominal
rigidities, for the reasons discussed by Kimball (1995). Hau (2000) rather
considers a case in which prices are flexible but nominal wages are predetermined.
Both product and labor markets are monopolistic, since each household supplies a
7An exception is Beaudry and Devereux (1995) which generates endogenous price stickiness as an
equilibrium in a stylized model of increasing returns to scale.
8However, Bergin (1995) makes arguments in favor of wage stickiness as preferable to price
9Obstfeld and Rogoff (1996, Section 10.4.2, pp. 709–711) provide a textbook treatment of Hau’s
model. Obstfeld and Rogoff (2000) analyze sticky wages in a stochastic environment (see Section 8

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
differentiated labor input. Facing a constant elasticity of demand, monopolistic
firms set prices as a constant markup over the wage. For this reason, since wages
are sticky, optimal prices also remain fixed in the short run and the factor market
rigidities in effect produce the same international transmission effects as the
domestic product price rigidities in the Redux model.
3.2. Staggering
Simultaneous one-step-ahead pricing has the counterfactual implication that the
price level experiences large, discrete jumps. Staggered price setting is an
alternative way to introduce price stickiness that permits smooth price level
adjustment. This staggering means that each firm must take into account the
previous and future pricing decisions of other firms in optimally setting its price.
Many authors follow Calvo (1983). The Calvo pricing assumption is that the
opportunity to adjust its price arrives stochastically to each firm. Independence
across a large number of firms means that a fixed fraction adjusts its price each
period so that the price level is a smooth variable and changes only gradually over
time: if the Poisson arrival rate of a price-change opportunity is g, a fraction g of
firms changes its price each period and 1 /g is the average interval between price
changes for a given firm.
As previously analyzed by Taylor (1980) and Blanchard (1983), staggering is a
potential persistence mechanism since the adjustment to a shock cannot be
achieved instantaneously. Kollman (1997) calibrates a model in which both prices
and wages are sticky. He compares predetermined price and wage setting to
Calvo-type adjustment rules in responding to monetary shocks and finds that
Calvo-type nominal rigidities perform better in matching the high observed serial
correlation of nominal and real exchange rates and the gradual adjustment in the
price level but less well in matching the correlations of output with other
macroeconomic variables.
In general, the responsiveness of prices and persistence depend on (i) the
sensitivity of prices to costs and (ii) the sensitivity of costs to output. Chari et al.
(1998a) show that staggering in itself does not generate endogenous persistence if
prices are a constant markup over marginal costs and if marginal costs are
increasing in the level of output. Under these conditions, a firm will raise its price
as soon as it is given the opportunity. However, if firms face convex demand
schedules, such that the price elasticity of demand is increasing in the price
charged, firms will be slower to raise prices. Moreover, Jeanne (1998) considers a
Calvo pricing model in which real wages are rigid, in the sense of being inelastic
10With identical and constant elasticity of demands across countries, it is hard to reconcile price
flexibility with violations of the law of one price (see Section 4 below). However, with internationalized
production by which local labor is used to produce for the local market, local wage stickiness can
translate into rigid prices in local currency, even when firms are free to costlessly alter prices.

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
to shifts in output and employment. He shows that a firm, when it receives the
opportunity to alter its price, only makes a small adjustment: if marginal costs are
rigid, optimal prices will also be sticky. Real-wage rigidity thereby amplifies the
real effects of monetary shocks and increases persistence.
Andersen (1998) makes the point that wage staggering is more likely to
generate persistence than price staggering, since wage stickiness implies that labor
demand rather than labor supply determines quantities in the labor market. For this
reason, the elasticity of labor supply is irrelevant in determining short-run
marginal costs. Finally, Bergin and Feenstra (1999, 2000), discussed below, show
how non-constant elasticity of demand and intermediate inputs can also generate
persistence in a staggering framework.
4. Market segmentation and pricing to market
By assumption, the law of one price always holds in the Redux model. Engel
(1999) and others have documented that international deviations in tradables prices
are responsible for a large proportion of real exchange fluctuations.
In line with
this empirical evidence, a number of authors have introduced international market
segmentation into the baseline model.
Segmentation means that at least some firms have the ability to charge different
prices for the same good in home and foreign markets. Second, it is assumed that
prices are sticky in each country in terms of the local currency. With identical CES
preferences across countries, even these firms will optimally select home and
foreign currency prices that are a constant markup over marginal cost and hence
the law of one price will be satisfied ex ante. In the event of a shock, however,
prices that are sticky in each local currency means that exchange rate movements
cause ex-post deviations from the law of one price. Pricing to market (PTM) in
combination with local-currency sticky prices, thereby allows the real exchange
rate to fluctuate and delinks home and foreign price levels.
4.1. Pricing to market
Betts and Devereux (2000a) modify the Redux model by assuming a fraction s
of firms can set different prices in home and foreign markets.
As such, the
11For surveys, see Rogoff (1996) and Devereux (1997).
12Since local-currency sticky prices, or destination market rigidities, are a key ingredient, the
argument that PTM is a mislabelling for the reason that PTM strictly refers to the ability of firms to
optimally choose different prices for different markets. However, the term is now commonly used in
the literature. Goldberg and Knetter (1997) refer to it as ‘short-term’ PTM to distinguish it from the
flexible-price version.
13Betts and Devereux (1996) lay out a static version of their model.

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
parameter s indexes the extent of PTM. Since the expenditure-switching effect of
exchange rate movements disappears under PTM, changes in the exchange rate
have a limited impact on consumption and hence the size of the exchange rate
movement required to satisfy the monetary equilibrium condition is enlarged. This
raises the possibility of short-run exchange rate overshooting, which is ruled out in
the Redux model.
Moreover, since home and foreign price levels are sticky, a movement in the
nominal exchange rate shifts the real exchange rate and delinks home and foreign
consumption growth. In contrast, the correlation of home and foreign output rises
since the domestic demand expansion raises demand for imports at the fixed
relative price of imports in terms of domestic currency. In this way, the model
generates international consumption and output comovements that are more in line
with the evidence on international business cycles. Finally, with full PTM (s 5 1),
the current account remains in balance, contrary to the surplus prediction in the
Redux model.
A noteworthy result is that an exchange rate depreciation can actually improve a
country’s terms of trade under PTM. The reason is that export prices are fixed in
terms of foreign currency so depreciation raises the corresponding domestic-
currency ‘price’ of exports without altering domestic-currency import prices.
Contrary to the Redux model, a surprise home monetary expansion can thereby
have a beggar-thy-neighbor effect by adversely affecting the foreign country’s
terms of trade. Relatedly, Betts and Devereux (2000a) shows how the presence of
PTM critically alters the parametric conditions under which a devaluation
improves the current account.
Betts and Devereux (1997) calibrate a version of their PTM model that allows
for staggering and capital accumulation. They show that the PTM model does well
in matching the conditional moments in the data and clearly outperforms the
PPP-based Redux model in tracking real exchange rate movements and generating
high international output correlations relative to consumption correlations.
Chari et al. (1998b) similarly calibrate a PTM model but rather attempt to match
the unconditional moments in the data. A key result is that, even when firms set
prices in staggered fashion, the model is unable to generate a persistent effect on
real exchange rates beyond the period of exogenously-imposed nominal stickiness.
As was noted earlier, the reason is that a flexible labour market means that
marginal costs rise in response to an increase in aggregate output. Since constant-
elasticity demand schedules mean that the optimal markup is fixed, an increase in
marginal costs induces firms to raise prices proportionally as soon as they have the
opportunity to make the adjustment.
4.2. Translog preferences
Bergin and Feenstra (1999) also study PTM but depart from the monopolistic
competition framework in which firms face constant-elasticity demand schedules.

P.R. Lane / Journal of International Economics 54 (2001) 235 –266
They consider translog preferences, by which the expenditure share for each good j
is inversely related to its relative price, which generate variable markups over
marginal cost. Following Basu (1995), they also introduce intermediate goods into
the production structure, so that marginal costs are heavily influenced by the
aggregate price level (good can be demanded either as intermediate inputs or for
final consumption). Firms are assumed to set prices in a staggered fashion. In this
setup, monetary shocks have persistent effects on real exchange rates, even after
all firms have had the opportunity to adjust prices. The intuition is that each firm is
reluctant to raise its price when other prices remain fixed both because an increase
in relative price reduces its expenditure share and because the fixed prices of other
goods means that the cost of intermediates, and hence total marginal cost, does not
rise quickly. A variable markup over marginal cost means that deviations from the
law of one price also persist. This stands in contrast to the other PTM models that
specify a constant elasticity of demand (and thereby a constant markup): in that
case, once firms are free to adjust prices, the law of one price will be re-
established. As such, PTM does not in itself generate endogenous persistence
beyond the length of the exogenous nominal rigidity in the model.
consequence of the slow adjustment induced by translog preferences is a larger
accumulation of net foreign assets and hence there is a bigger long-run impact on
the real exchange rate.
An interesting feature of the model is that, if the parameters for the interest and
consumption elasticities of money demand are set so as to induce exchange rate
overshooting, persistence raises the volatility of exchange rates: since the interest
rate differentials persist for several periods, the exchange rate must be expected to
depreciate for several periods consecutively and, as such, the initial jump in the
exchange rate must be more extreme. That said, a larger exchange rate response
alters marginal costs and hence induces faster price adjustment, reducing the
persistency of the impact of a monetary shock on real variables such as the level of
As shown by Bergin and Feenstra (2000), both translog preferences and
intermediate inputs can independently generate endogenous persistence, with the
implication that only one of these features need be present to deliver persistence.
However, they also show that there is a positive interaction between the two
mechanisms: a greater share for intermediates in the production function generates
more persistence under translog preferences than under CES preferences.
5. Preferences and technology
Specifying household preferences is a key decision in any micro-founded
model. There is a long list of critical parameters to be selected, including the
14Indeed, as shown by Friberg (1998), such concavity in the demand function is a necessary
condition for risk-averse firms to find it optimal to preset export prices in the foreign currency.