New Open Economy Macroeconomics

A new line of literature has started in the early 1990s that incorporates imperfect com­petition and sticky prices in infinite-horizon two-country models. This approach tackles all three shortcomings listed above: (1) all choices by individuals and firms can be clearly addressed; (2) the inter-temporal optimization of individuals, firms, and the government cares for the inter-temporal budget constraints, which are important in many policy contexts; and (3) the micro-foundation delivers a welfare metric to compare alternative policy measures.

Obstfeld and Rogoff assume that individuals maximize their inter-temporal utility function with respect to their inter-temporal budget constraint. Utility is thereby posi­tively affected by each period’s consumption and non-interest bearing money holding, and negatively affected by the amount of time spent on working. In contrast to the tra­ditional Keynesian models, the consumption bundle consists of a number of differenti­ated varieties, which include imported varieties from the foreign country. Each variety is produced by one single producer-household. In the production process which is the same for all varieties only labour is used. The horizontally differentiated varieties are supplied in monopolistic competition. The varieties are symmetric in their effect on utility. The composition index, on which utility depends, has the constant elasticity of substitution (CES) form which assumes an equal and constant elasticity of substitution between any two varieties. This elasticity is assumed to be the same in both countries.

Inter-temporal utility maximization of the representative individual relies on con­sumption shifting between the periods achieved by trading of a riskless asset on a perfectly integrated international financial market or by holding cash.

The consumer-producer chooses his consumption level, money holding, and working time by equating his or her respective marginal utilities in the present period. In addi­tion, all periods’ marginal utility from consumption must be equalized. That is expressed in the Euler equation, which must hold. This inter-temporal consumption smoothing is the most important difference to the traditional Keynesian models. Consumption does not depend on current income alone but on lifetime income, that is, wealth. Changes in current income change the individual’s wealth. The effect of a change in current income on consumption is spread over many periods. A wealth increase raises consumption and money holding but reduces labour input because the marginal utility of consumption and money holding falls, which requires the marginal utility of leisure (which is the time left after working) to fall too. Increasing wealth goes therefore along with reductions in output.

In the long run, prices adjust to their stationary equilibrium level. In the short run, however, prices are assumed to be fixed and pre-set in the previous period which can be motivated by menu costs. That requires demand to determine output if the shock that pushes the economy out of equilibrium is not too large. Because the monopolists set prices always above marginal costs, they can satisfy demand at their pre-set price. By assumption, prices are set in producer’s currency.

While the exchange rate behaves as in monetary models, economic policy is effective in the new open economy macroeconomics framework. For instance, a permanent expan­sion of money supply in the home country increases individuals’ wealth, which raises consumption in the current period and in the long run. Output increases in the demand- driven short run and falls in the long run, when prices adjust. Increased consumption is partly satisfied by imports of foreign goods, as demand for all goods (including imports) rises. However, output rises even faster than consumption because inter-temporal utility optimization requires shifting some of the wealth gains to the future. The home country does therefore run a current account surplus in the short run. This surplus is adminis­trated by the depreciation of the exchange rate. The falling exchange rate reduces the pre­set prices of home goods in terms of the foreign currency in the foreign country, which in turn induces foreign consumers to substitute home goods in the short run. In the long run, individuals in the home country realize higher consumption by enjoying net imports from the foreign country. Price adjustment raises prices at home even more than pro­portional to the money shock. Rising prices over-compensate the nominal exchange rate depreciation. Home’s terms of trade improve relative to the initial situation. The rising prices induce the individuals to work less. Thus, monetary shocks have long-lasting real effects.

One great advantage of the new open economy macroeconomics approach is the welfare analysis, which is possible in this framework. The representative individuals in both the home country and the foreign country increase their inter-temporal utility if the home country conducts a small, unanticipated monetary expansion. This stems from the increase of world demand induced by the monetary expansion in the initial period, which is shared by both countries. The money shock reduces the inefficiency in production resulting from the fixed mark-up as in Blanchard and Kiyotaki (1987). The higher aggregate demand with pre-set prices forces higher work effort in the short run and pushes the economy closer to efficient production. That implies that the expendi­ture switching “beggar-thy-neighbour” effects of Mundell-Fleming-Dornbusch models might be overstated and the general inflationary effect that reduces the world interest rate is more important.