Challenges
Empirical tests identify the two main challenges for further refinements of the new open economy macroeconomics (NOEM) approach. The results indicate direct and indirect support for both local currency pricing and producer currency pricing.
That is troubling because the policy advice in both models differs a lot. Yet, the observed low pass-through might stem from other sources than local currency pricing (such as the distribution chain) and might therefore be compatible with expenditure switching effects. Moreover, currency invoicing of exports and imports should be endogenous (Bacchetta and van Wincoop 2005). Firms in countries with a stable monetary policy should opt for producer country pricing of their exports whereas exporters from countries with unstable monetary policies choose to stabilize their mark-ups by invoicing in importers currency. In addition, Goldberg and Tille (2008) present evidence for invoicing in a third (vehicle) currency, something that cannot arise in a two-country model. This vehicle currency denomination is well explained by industry characteristics as opposed to macroeconomic effects and the need of producers to match prices set by competitors located in other countries.Overall, the models seem to overstate the effects of economic integration of countries. Even within the European Union, the cross-border transmission of shocks is by far smaller than the models would suggest. Obstfeld and Rogoff (2001) claim that the introduction of plausible iceberg trade costs in standard international macroeconomics models could explain the several - six - major puzzles, including the low-consumption- correlation puzzle, which expresses the observation that the high degree of consumption smoothing and therefore risk sharing implied in the models is not matched by consumers behaviour found in data.
Yet, the most severe challenge is posed by the failure of the models to predict exchange rate movements.
Exchange rate movements are necessarily explained by fundamentals in the models. The models rely on both the law of one price and the uncovered interest parity, neither of which find overwhelming support in empirical studies. Even worse, empirically, the exchange rate is barely related to any macroeconomic variable in noncrisis situations. Note the large fraction of exogenous deviations from the purchasing power parity in explaining exchange rate movements in Lubik and Schorfheide (2006). This dissatisfactory phenomenon is found in so many studies that it even got a name: the exchange rate disconnect puzzle (Obstfeld and Rogoff 2001). For a theoretical framework that has been started to explain the transmission of monetary and exchange rate shocks between countries, exchange rate disconnect is frustrating and calls for more research.Notwithstanding the poor performance in predicting exchange rate movements, central banks (which are usually mainly interested in domestic prices and output forecasts) all over the world have been using the framework for policy analyses (Smets and Wouters 2003, for example). They calibrate problem-tailored versions of NOEM models on specific situations of their economy to conduct quantitative policy analyses. NOEM models have thus become the workhorse of quantitative models to evaluate economic - and particularly monetary - policy.
The NOEM framework mainly concentrates on flexible exchange rate regimes. However, the debate about the appropriate exchange rate regime has not been spurred by the new framework. The small interest in fixed exchange rates has three roots: first, the main currencies float; second, there has been found little difference in the short-run behaviour of macroeconomic variables in countries with fixed relative to those in flexible exchange rate regime countries (exchange rate disconnect puzzle: Obstfeld and Rogoff 2000; Devereux and Engel 2002); and third, when studying fixed exchange rates using the small-economy version of the NOEM framework, very low welfare costs of exchange rate pegs have been found (Kollmann 2002; Gali and Monachelli 2005). The euro area with its within-pegged exchange rates has been changing this focus on flexible exchange rates (see Schmitt-Grohe and Uribe 2012). Given the continuing crisis in the European Monetary Union (EMU), a deeper understanding of the functioning of a currency union is desperately needed.
JθERN KLEINERT