# The new open economy macroeconomics: a survey

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Journal of International Economics 54 (2001) 235–266

www.elsevier.nl / locate / econbase

The new open economy macroeconomics: a survey

*

Philip R. Lane

Received 28 July 1999; accepted 20 December 1999

Since the 1995 publication of Obsteld and Rogoff’s

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.

This article surveys some recent efforts to develop a new workhorse model for

1

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.

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: / / www.princeton.edu / |bmdoyle /

open.html.

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

236

2

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

(1997).

The rest of the paper is organized as follows. The Obstfeld–Rogoff

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.

237

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

concludes.

As was noted in the Introduction, Obstfeld and Rogoff (1995a) effectively

3

initiated this new research program. In this section, we brieﬂy outline the main

features of their

populated by a continuum of yeoman-farmers (consumer-producers) that produce

differentiated goods ([0,

4

Preferences for individual

12´

s

x

k

s 21 /s

m

]]

1 ]]

]

2 ]

(1)

F

S D

s 2 1

1 2 ´

m

G

where s, ´ . 0, m . 1, 0 , b , 1 and

differentiated varieties of the consumption good

1

u /u 21

u 21 /u

d

u . 1

(2)

3

4

0

where u is the elasticity of substitution between varieties. Goods [0,

produced domestically and (

symmetrically into preferences. The corresponding price index is

1

1 / 12u

12u

d

(3)

3

4

0

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

2u

F ]G

(4)

where

3The working paper version was released in April 1994 as

4Analagous equations hold for the representative individual in the foreign country.

238

by the government. Assuming zero government consumption, the revenue earned

from money creation is returned in the form of transfers (

0 5

(5)

Agents have access to an international riskless real bond market at the constant

interest rate

1

1

(6)

where

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

utility.

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

239

(7)

(8)

(

(9)

(

(10)

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 (

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

5

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

6

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

balances.

6The mechanism is exactly the aggregate demand externality highlighted by Blanchard and Kiyotaki

(1987).

240

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

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.

The literature typically introduces nominal rigidity as an exogenous feature of

7

the environment. In the

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.

The literature has largely emphasized price stickiness as the locus of nominal

8

rigidities, for the reasons discussed by Kimball (1995). Hau (2000) rather

9

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

stickiness.

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

below).

241

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

10

domestic product price rigidities in the

3.2.

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.

242

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.

By assumption, the law of one price always holds in the

(1999) and others have documented that international deviations in tradables prices

11

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

12

rate to ﬂuctuate and delinks home and foreign price levels.

4.1.

Betts and Devereux (2000a) modify the

13

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.

243

parameter

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

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 (

the current account remains in balance, contrary to the surplus prediction in the

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

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

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.

Bergin and Feenstra (1999) also study PTM but depart from the monopolistic

competition framework in which ﬁrms face constant-elasticity demand schedules.

244

They consider translog preferences, by which the expenditure share for each good

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

14

beyond the length of the exogenous nominal rigidity in the model.

One

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

output.

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.

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.

www.elsevier.nl / 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

**Abstract**Since the 1995 publication of Obsteld and Rogoff’s

*Redux*model, there has been anoutpouring 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

1

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: / / www.princeton.edu / |bmdoyle /

open.html.

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

236

*P*.*R*.*Lane*/*Journal of International Economics*54 (2001) 235 –2662

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

(1997).

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 –266237

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

concludes.

**2. Exchange rate dynamics redux**As was noted in the Introduction, Obstfeld and Rogoff (1995a) effectively

3

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 ispopulated 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).4

Preferences for individual

*j*in the home country are given by12´

s

x

*M*k

*s*2*t*s 21 /s

*s*m

*U*5O b]]

*C*1 ]]

]

2 ]

*y*(*z*)(1)

F

*s*S D

*s*s 2 1

1 2 ´

*P*m

G

*s*where s, ´ . 0, m . 1, 0 , b , 1 and

*C*is a CES index aggregating across thedifferentiated varieties of the consumption good

1

u /u 21

u 21 /u

*C*5 E*c*(*z*)d

*z*u . 1

(2)

3

4

0

where u is the elasticity of substitution between varieties. Goods [0,

*n*] areproduced domestically and (

*n*, 1] overseas: home and foreign goods entersymmetrically into preferences. The corresponding price index is

1

1 / 12u

12u

*P*5 E*p*(*z*)d

*z*(3)

3

4

0

*M*/*P*are the real balances held in period*t*and the last term in (1) captures the*t**t*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

2u

*p*(*z*)*w**y*(*z*) 5 ]F ]G

*C*(4)

*P**w*where

*C*is aggregate global consumption. Money is introduced into the economy*t*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.

238

*P*.*R*.*Lane*/*Journal of International Economics*54 (2001) 235 –266by the government. Assuming zero government consumption, the revenue earned

from money creation is returned in the form of transfers (

*T*, 0)*t**M*2*M**t**t*210 5

*T*1 ]]](5)

*t**Pt*Agents have access to an international riskless real bond market at the constant

interest rate

*r*. The dynamic budget constraint is given by*j**j**j**j**P B*1*M*5*P*(1 1*r*)*B*1

*M*1

*p*(*z*)*y*(*z*) 2*P C*2*P T*(6)

*t**t**t**t**t*21*t*21*t**t**t**t**t**t**j*where

*B*is agent*j*’s bond holding entering period*t*1 1.*t*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

utility.

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 –266239

*˜**˜**˜**¯**¯**¯**E*5*P*2*P**;*E*5*P*2*P**(7)

*˜**˜**¯**¯**C*2*C** 5*C*2*C**(8)

*˜**˜**˜**˜**˜*(

*M*2*M**) 2*E*5*C*2*C**(9)

*¯**¯**¯**¯**¯*(

*M*2*M**) 2*E*5*C*2*C**(10)

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

5

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

6

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

balances.

6The mechanism is exactly the aggregate demand externality highlighted by Blanchard and Kiyotaki

(1987).

240

*P*.*R*.*Lane*/*Journal of International Economics*54 (2001) 235 –266required 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 subsequentwork. 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

7

the environment. In the

*Redux*model, ﬁrms simultaneously set prices one periodin 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

8

rigidities, for the reasons discussed by Kimball (1995). Hau (2000) rather

9

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

stickiness.

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

below).

*P*.*R*.*Lane*/*Journal of International Economics*54 (2001) 235 –266241

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

10

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.

242

*P*.*R*.*Lane*/*Journal of International Economics*54 (2001) 235 –266to 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

11

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

12

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*13

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 –266243

parameter

*s*indexes the extent of PTM. Since the expenditure-switching effect ofexchange 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 therebyhave 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 generatinghigh 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.

244

*P*.*R*.*Lane*/*Journal of International Economics*54 (2001) 235 –266They consider translog preferences, by which the expenditure share for each good

*j*

is inversely related to its relative price, which generate variable markups overmarginal 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

14

beyond the length of the exogenous nominal rigidity in the model.

One

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

output.

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.