RECENT INNOVATIONS TO OPEN-ECONOMY MACROECONOMICS
RECENT INNOVATIONS TO OPEN-ECONOMY MACROECONOMICS
The recent advances in open economy macroeconomics come in two gen- eral types. The first assumes that the economy responds quickly so that an equilibrium is reached quickly, whereas the other type of models have some short-run restriction to prevent an equilibrium in the short run.
The so-called equilibrium approach to exchange rates assumes that prices, interest rates, and exchange rates are always at their market clear- ing equilibrium levels. In this approach, changes in exchange rates occur because of changes in tastes or technology and are part of the adjustment to a shock to the world economy. For instance, suppose an improvement in technology in Switzerland increases Swiss output, and at the higher level of productivity the price of Swiss goods relative to other countries’ goods falls through a depreciation of the franc. The lower relative price of Swiss output is associated with rising Swiss exports. In this scenario,
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of these changes. Similarly, if tastes had changed so that Swiss goods were now more favored by consumers, this would increase the relative price of Swiss goods and would be associated with a franc appreciation. In this view of the world, exchange rate changes can never be viewed as good or bad—they simply occur in response to some other event and are part of the adjustment to a new equilibrium.
Another recent approach to explaining exchange rates assumes that in the long run the equilibrium approach is reached, but in the short run restrictions to price movements result in temporary disequilibria that result in large exchange rate variability. Essentially these models combine elements of the IS-LM-BP framework from Chapter 13 with the mone- tary approach. While these new models are too complex to be covered in detail here, we should realize where economic thought is moving and the implications of this new thinking. The New International Macroeconomics carefully considers the details of the economy to the level of individual firms and households and how their actions aggregate to macroeconomic phenomena.
The IS-LM-BP model focused on one country and abstracted from the rest-of-the-world, which is in the background. The New International Macroeconomics typically examines two countries (you might think of one as the rest-of-the-world) and the determination of key macroeco- nomic variables like incomes, prices, and the exchange rate. The predic- tions of this type of model would include the following effects of a surprising increase in the domestic money supply: consumer spending increases at home and abroad; domestic income increases by more than foreign income; the domestic currency depreciates and purchasing power parity is maintained continuously.
The IS-LM-BP model was developed holding the price level constant. In many New International Macroeconomic models the price level is held fixed for a short run and then allowed to change in the long run as in the monetary approach. So the short-run fixed price is like the old model, but the long run allows for a dynamic adjustment of prices over time that is missing from the static models of the IS-LM-BP type.
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price”) so that there is no inducement for changes in consumption or production. So the assumption of “sticky prices” is important to generate changes in spending and output.
Since there is much evidence against the law of one price, some research has focused on a modified version of a New International Macroeconomic model that allows for pricing to market. This occurs when local currency pricing reflects local market conditions in each country and allows for price discrimination across countries. In this case, purchas- ing power parity does not hold and so changes in the money supply of one country may result in bigger exchange rate changes due to the rel- ative lack of responsiveness of price levels across countries. This is an important change since we observe real-world exchange rates having much greater volatility than relative prices across countries.