New Open Economy Models

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New Open Economy Models: An Overview

Sukumar Nandi

Indian Institute of Management Lucknow

Oh, you cant help that, said the Cat; were all mad here.

Im mad. Youre mad.

.Alice didnt think that proved it all; however, she went on.

And how do you know that youre mad?

To begin with, said the Cat, a dogs not mad. You grant

that?

I suppose so, said Alice.

Well, then, the Cat went on, you see, a dog growls when its angry,

and wags its tail when its pleased. Now I growl when

Im pleased, and wag my tail when Im angry. Therefore

Im mad.

[Alices Adventure in Wonderland

- Lewis Carroll ]-

A series of papers published since late 1980s had changed the main theoretical

contours of traditional international economic theories. The latter had largely beenbuilt onthe solid foundations of Heckscher- Ohlin model, though some extensions had

been achieved in some papers published in the 1980s. These were mainly concerned with

the inclusion of the assumptions of imperfect competitions, counter trade and to some

extent price rigidity. But the basic premise of the H O model remained intact. Whilethe pure theory of international trade remains tied to H - O framework, the monetary

theory , i..e., balance of payments and exchange rate determination had been built upon

either the Keynesian framework or the monetarist framework.

In 1995 Maurice Obstfeld and Kenneth Rogoff (henceforth OB-RO) jointly

published a paper (Obstfeld and Rogoff, 1995) that started a series of researchchanging many assumptions of traditional theory of international economics. The basic

model of OB-RO is a two- country dynamic general equilibrium model with the

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provisions of nominal price rigidities, imperfect competition, and a continuum of agents

who both produce and consume. Each agent produces a single differentiated good and all

of them have identical preferences. The latter are characterized by an intertemporal utilityfunction that depend positively on consumption and real money balances but negatively

on work efforts. The work efforts are positively related to output. While two countries are

home and foreign, exchange rate is the price of foreign currency in terms of homecurrency. The exchange rate works as the bridge between the domestic price and the

foreign price.

The OB OR model assumes that there are no restrictions on internationalmovements of commodities. This implies that law of one price ( LOP) holds for

individual commodity and internationally identical commodity basket is governed by

purchasing power parity ( PPP), i.e., each traded commodity attracts the same price when

converted to a single international currency. Strict version of PPP implies a fixed realexchange rate, as the later is defined as the nominal exchange rate adjusted for relative

national price levels, or,

RER = NER x ( CPI / CPI * )

Where CPI and CPI* are price levels of home and foreign respectively. Thus twinassumption of LOP and continuous PPP imply a fixed RER for the home country. When

PPP holds only in the long run and not on continuous basis, RER may have fluctuations

over time.

OB-OR model assumes that two countries can borrow and lend in the integratedcapital market of the world. The only asset traded internationally is the risk free real bond

denominated in consumption good. Agents maximize their lifetime utility subject to

budget constraint.Each agent decides his optimal choice of consumption, money holding, labour

supply and also determine the price of his output. Nominal rigidity is introduced into the

model by fixing prices one period in advance. The system is first solved for the steadystate of the model. A log-linear approximation is made of the steady state to study the

effects of a monetary shock. Since prices are sticky for one period , the solution

distinguishes between the impact effects of a sock and the long run steady state effects.The welfare effects of a shock are the sum of the short run change of utility and the long

run change in steady state utility.

The model also considers the experiment of an unanticipated permanent increasein domestic money supply ( a la Dornbusch). The effects of an monetary shock is an

increase in output and consumption. The real interest rate of the world declines and a

nominal depreciation of domestic currency boils down to a decline to domestic terms oftrade. Both these factors lead to an increase in foreign consumption. Since the increase in

aggregate consumption and the shift in relative prices work in opposite dimension,

the effects on foreign output are ambiguous. The current account of the home countrymoves to a surplus. This implies a permanent improvement in net foreign assets. When

the latter is translated to positive net investment income inflow, this increases

consumption permanently above domestic output and that leads to a domestic trade

deficits. Again the wealth effects of an increase in net foreign assets reduces domestic

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labour supply, as leisure consumption increases, domestic output declines and this leads

to a permanent improvement in the home countrys terms of trade. Thus money is not

neutral in this model.In the model the monetary shocks impact on home and foreign welfare can be

calculated. For that the different effects of the money shocks on consumption both in

short run and in long run , real balances and leisure can be aggregated adjusting to therespective weights implicit in the utility function. It follows from the model that home

and foreign welfare increase in the same proportion, though the output effects of the

shock are asymmetric. This is because the first order effects of the monetary shocks arethe initial increase in world demand. But the distortions will be there because of

imperfect competition, and that initial levels of output will be too low compared to world

total, a demand- driven increase in world output increases welfare to the equal benefits of

both countries.

14.1. Extension of OB-RO Model

The OB-RO model has been extended by later research works. Nominalrigidity is one particular assumption. Harald Hau has generalized the model in three

ways with the objective of investigating the role of factor price rigidities and

nontradables for the international transmission mechanism ( Hau, 2000). First, the model

allows for factor markets and also for nominal rigidity originating from sticky factorprices. Second, Haus paper also allows for nontraded goods.

Third, it is assumed that there is no international goods arbitrage and there is

flexible price setting in local currency. Because of optimal monopolistic price fixation,law of one price still holds, though nontradables in the consumer price index will create

deviations from purchasing power parity.

The main result of the Haus paper is that factor price rigidities have similarimplications to rigid domestic producer prices. In the context of a market structure with

factor price rigidities, the conclusion of OB-RO model is confirmed here also. However,

a large share of nontradable goods in consumers budget implies that exchange ratemovements are magnified, because money market equilibrium depends on a short run

price adjustment that are associated with fewer tradable commodities. This is important

as this effects may explain the high volatility of the nominal exchange rate relative to

price fluctuations as observed in the market.

14.2. The Steady State Again

In OB-RO framework, current account plays an important role in the transmission

of shocks across the countries. But the steady state is indeterminate and both the

consumption differential between countries and the net foreign assets of a country arenon-stationary in character. After a monetary shock the economy will move to a new

steady state, and continue there till another shock arrives. Later formulations of OB-RO

have not emphasized the role of net foreign assets accumulations as a channel of

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macroeconomic transmissions between countries. This is achieved with two assumptions:

(i) the elasticity of substitution between domestic and foreign goods is unity, and,

(ii) financial markets are complete in the sense that international capital market iscomplete with perfect capital mobility.

Under complete financial markets and law of one price, full risk- sharing means that there

will be no shift in wealth between countries arising out of monetary shocks. This makesthe persistence channel non-functional, and there is no longer a shift in relative wealth

having a permanent effects on relative labour supplies, that causes permanent effects on

relative prices and outputs. Because of these, the assumption of complete markets helpsto simplify the analysis by denying both the current account and net foreign assets

the role of dynamic propagation mechanism.

The two assumptions (i) and (ii), by denying the current account to generate

dynamic persistent effects have helped for the achievement of the determinacy of thesteady state. The assumption may be strong, but the role of current account dynamics in

the generation of persistent effects of transitory shocks have also been found to be

quantitatively not important in the literature (Kollman, 1996).

14.3. Uncertainty and Stochastic Nature

OB- RO ( 1998) has introduced the effects of an unanticipated monetary shock in

a sticky price general equilibrium model with a stochastic setting. Thus monetary

uncertainty is introduced by assuming home and foreign money stocks follow log-normalstochastic process. Since uncertainty affects equilibrium prices, it has effects on expected

consumption levels, the terms of trade and also relative output levels. For example, if

the home country faces monetary uncertainty, the corporate of this country will add a riskpremium in the prices of commodities. This will reduce production, but will improve

terms of trade. Thus uncertainty has first order effects on equilibrium welfare levels.

These effects are symmetric on welfare levels of both countries, home and foreign,despite ex-ante differences in price setting and ex-post differences in relative output

levels. This induces both the countries to design an optimum global exchange rate

system, and this will old irrespective of the relative size of home and foreign countries.

The model as developed in OB- RO ( 1998) has another interesting implication.

Regarding its predictions for asset pricing, the risk premium on a volatile currency may

be negative if exchange rate movement hedges consumption volatility. This againexplains a puzzle related to forward premium : a high inflation country may have a

relative volatile and unstable currency that hedges consumption risk, and thus it

simultaneously generates a positive expected depreciation and a negative forwardpremium. Also monetary uncertainty has magnified effects on the level of exchange rate

relative to the forward premium. When the latter is volatile, the analysis then provides an

explanation for the high volatility of the level of exchange rate. This also explains thatnot only high interest rate leads to potential depreciation of the currency, but the

expectation of an depreciation of the home currency due to monetary shock may increase

the interest rate.

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The results obtained above in the extended OB-RO model are based on the

assumptions specific to the model along with the micro foundations. This aspect has been

questioned in subsequent literature and some papers have attempted to relax some strongassumptions ( Sarno, 2001).

14.4. Equilibrium Exchange Rate and Pass-through

Empirical evidence in the literature indicates that changes in the nominal

exchange rates are not fully passed through to the prices of commodities. It seems thatconsumer prices are not very responsive to nominal exchange rate changes. One

implication of this that the expenditure switching effects of exchange rate changes

might be very small, which means that a change in the nominal exchange rate might not

lead to much substitution between domestically produced commodities andinternationally produced commodities, as the relative prices of the commodities do not

change much for the consumers.

When the exchange rate changes have small effects on the behaviour of final

users of commodities, it will require large change in the exchange rates to achieve

equilibrium after some initial shock to fundamentals. Suppose there is a shock thatreduces the supply of imported commodities, that implies that a very large home

depreciation might be required in order to increase the relative prices of imported

commodities enough to reduce demand for that sufficiently. This shows that low pass-through of exchange rates may imply high exchange rate volatility in equilibrium.

The central issue is market segmentation and practice of local-currency pricing of

traded commodities. This practice of local- currency pricing impedes the linkages ofcommodity prices across the countries that again cause the deviations from purchasing

power parity (PPP) doctrine and also high exchange rate volatility. But there are some

caveats to this conclusion and these are as follows.First, international finance markets often allow for complete risk sharing across

countries. This means that exchange rate will be determined by risk sharing condition, in

spite of the fact that local currency prices are independent of exchange rate movements.

Second, even in situation of limited risk sharing in the sense as above, the linkageof asset prices through bond markets will impose a very narrow limit of exchange rate

movements, and that rules out high volatility.

Apart from local-currency pricing, two other factors are added in the literature to

explain high volatility of exchange ratesheterogeneity in the distribution of

internationally traded commodities and the existence of noise traders in the foreignexchange markets. The first comes through the way commodities are sold and prices

are set in the international markets. Some firms market their products directly, while

others have foreign distributors. In the latter case the exporters set the price in home

currency, and the distributors translate that in the currency of the importing country. The

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second one, i.e., traders adjusts changes in the exchange rate changes by the information

of interest rate differentials. The expectations of these traders regarding the interest rate

changes are said to be conditionally biased as reported in empirical literature (Devereux,2002 ). All these cause high volatility in the exchange rate while the economy reaches

equilibrium.

14.5. More on Microstructure of Exchange Rate

There has been further research to explain the short run volatility of the exchange

rate. It is argued that dispersed information is rapidly summarized in the public quote of

macro variables. This contention is challenged in recent literature ( Lyons, 2002). Theargument is as follows. The market information of important macro variable like

exchange rates gives a set of information in abstractform and the argument in favour of

this abstraction is not tenable as it lacks empirical support, while dispersed information

approach ( Payne, 1999, Evans and Lyons, 2002) has better credibility so far as empiricalsupport is concerned.

The difference between the public information approach and the dispersedinformation approach is the importance of the variable order flow in the latter. Order flow

is a concept borrowed from microstructure finance. The latter has two main strands

market design and information processing. The latter is important for dispersed

information approach as it borrows heavily from it. Order flow concept also belongs to it,i.e., information processing.

Order flow is transaction volume that is signed according to whether the

transaction is initiated from the buy side (+) or the sell side ( - ). Over time order flow ismeasured as the sum of signed buyer- initiated and seller- initiated orders. A positive sum

means that net buying over the period. Order flow as a concept has some similarity withexcess demand , but with a difference. Excess demand will be zero in equilibrium, butthis is not the case with order flow. In foreign exchange market, orders are initiated

against a market maker, who stands ready to absorb imbalances between buyers and

sellers. These uninitiated trades of the market maker make the difference between thetwo concepts -- excess demand and order flow.

Order flows convey information about dispersed fundamentals because these

contain the trades of those who analyze those fundamentals. It is a transmissionmechanism. The dispersed information approach (DPA) may speak to longer horizon

exchange rates in the same way that microscopes speak to pathologies with micro impact.

This helps solve the puzzles in exchange rate movements like why the latter are virtuallyunrelated to macroeconomic fundamentals or, why exchange rates are excessively

volatile. The DPA links these puzzles with another important phenomenon ---- how

market participants form their expectations of future fundamentals--- and this DPA doesthrough expectation formation. The focus is on information types and how information

maps into expectations. The issue of information type and mapping to expectations are

the important tools of analysis of the microstructure finance to resolve the puzzles as said

earlier.

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14.6. Stabilization Programme in Crisis Economies:

Monetarist Approach and Polak Model

Money supply is recognized as one of the determinants of aggregate demand of

the economy. When we treat money supply as a policy variable, we implicitly assumethat the monetary consequences of payments imbalances are sterilized. It is recognized

that when devaluation of exchange rate increases price level, it reduces the real money

balances and so it reduces real demand. Therefore, money is important, and themonetarist approach starts with placing money at the core of the argument.

The monetary approach to balance of payments was developed by two

schools. The first was based at University of Chicago under the leadership of Robert

Mundell and Harry Johnson. The second was initiated by J.J. Polak at IMF and thejustification of the new approach as stated was that it would try to develop models that

would be usable to monitor macroeconomic management when only rudimentary

statistical information is available. We develop the Polak model briefly in the following

paragraphs.The objective of the model was to study the effects on both income formation and

the balance of payments of the two important exogenous variables autonomous changesin exports and the creation of domestic credit. A model that requires to reveal the effects

of these two variables needs a demand for money function.

In a simplified banking system of a country the consolidated balance sheet willreveal the identity:

Money supply = Reserve + Domestic Credit , or,

H = R + D Equation ( 14.1)

When there is a deficit in the balance of payments, it implies a loss of internationalreserve. It follows then from Equation (13.1) that there must a counterpart to a deficit in

balance of payments in the form of either credit creation (sterilization) or dehoarding

(which implies a fall in H ). Since dehoarding is a disquilibrium phenomenon ( and atemporary thing), a payments deficit can persist only if it is accompanied by credit

creation. In other words, any additional credit creation will ultimately leak out abroad.

This is the central theorem of monetary approach to balance of payments. In this category

the Polak model is a model of payments adjustments under a fixed exchange rate regime.

The Polak Model is based on a number of assumptions. First, the country is

having a fixed exchange rate regime and capital mobility is not allowed. Second, exportsare treated as exogenous and so is the domestic credit creation. So the latter can be

treated as a policy variable. Third, velocity of circulation of money is constant. This

enables one to normalize velocity as unity, and then one can write without no loss togenerality:

Y(t) = H (t) Equation (14.2)

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Fourth, imports are always a fixed proportion ( m ) of the value of nominal income with

one period lag, or,

M(t) = m. Y (t-1) Equation (14.3)

This is rather a simplifying assumption, as it means that the propensity of import isindependent of whether a given nominal income is the result of high price level and low

output, or high real output and low price level.

The model is completed by the money supply and balance of payments identities:

H(t) = R (t) + D(t) Equation (14.4)

R(t) = X(t) M(t) Equation (14.5)

And the symbols are:

H = Money supplyR = Monetary reserve

D = Domestic creditX = exports

M = Imports

= a change operator

A substitution of equations ( 13.3) and (13.4) into equation (13.2) gives,

Y(t) = H (t)= H (t-1 ) + H (t)

= Y (t-1 ) + R (t) + D (t) Equation (14.6)

Equation (13.6) gives the basic monetary theorem. Since in equilibrium,

Y (t) = Y ( t-1),

A payments deficit ( that is R < 0 ) can persists only when domestic credit creation is

positive or, D > 0.

The dynamic nature of the model derives from the fact that it contains both

income and the change in income. The solution of the model gives the endogenously

determined values of income, changes in the reserve and change in the domestic credit ofthe banking sector.

The model is simple but robust. The message is clear that any expansion ofdomestic credit will create disequilibrium in the domestic money market and the spill

over in the external sector will make the balance of payments worse. Based on this

conclusion IMF has traditionally given to limiting domestic credit expansion as an

important element of programme of the adjustment in balance of payments. The implicit

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assumption is that the fall in nominal income ( a result of limiting domestic credit) will

come through fall in price level and not through a fall in real output. But the critics argue

that the contraction of domestic credit may lead to a fall in output.

Critics of the IMF stabilization programme argue that IMF uses same programme

for all countries without realizing that conditions may differ. Recent experience of thestabilization programme in countries like Russia, Argentina, and even in some countries

in south Asia has not been good. Some countries have suffered severe contraction in GDP

that have caused huge unemployment.

As if in response to the critics arguments, Polak ( 1997) in a recent paper has

argued that the model addressed the persistent problems of the late sixties and early

seventies of last the 20th century. But thw world financial system has undergone somefundamental changes during the last two decades. For this IMF should consider some

modifications in its policies while applying the model. Polak suggests three changes and

these are:

First, the flexibility of international capital movements imply that that variablecan no longer be treated as exogenous as in the original model. Capital movements

depend on domestic interest rates and exchange rate expectations. The requiredmodification is a challenge to IMF.

Second, in the present scenario domestic interest rate depends strongly on the size

of the government deficit irrespective of the mode of financing of it, that is, whether that

deficit is financed from the banking system or in a domestic capital market. The interestrate is not in the model, but that should be accommodated.

Third, the exchange rate is to be incorporated in the model, as it is important in its

effects on the trade flows and also on inflation expectations.Though Polak argues for the extension of his original model on lines suggested by

him, he has not done the necessary extension. In the absence of that he rather suggests

that IMF should take into account some other macroeconomic conditions of the countrybefore setting forth the conditionality1.

14.7. G-3 Exchange Rate Volatility

In recent times the exchange rates of US dollar, yen and Euro are going throughlarge fluctuations and this volatility has caused huge problems in the stabilization

programme of developing countries. This is because the latter have tied their currency to

US dollar and the volatility in dollar / yen and dollar / Euro rates are creating stabilityproblems in their exchange rates.

In an important paper Reinhart and Reinhart ( 2002) have tried to address thisissue with the hypothesis whether there is a trade off between the exchange rate and

1 In the absence of a theoretically sound model, the IMF has recently tended to adopt an all risk policy

regarding its approach to CIS countries with a triple set of conditions: a ceiling on domestic credit, a floor

under net international assets, and an indicative target for base money.

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interest rate volatility. The paper reviews the traditional North- South links through trade,

commodity markets and capital flows. It also adds transmission channels in the form of

interest rate and exchange rate volatility. The empirical part of the paper finds no clearsupport for the hypothesis that limiting G-3 exchange rate volatility is desirable from the

perspective of the emerging market economies.

Ricardian Equivalence

Ricardian Equivalence (RE) implies that government budget imbalance is

irrelevant to resource allocation. If in a particular year the government goes for higher

expenditure based on huge deficit, the citizens understand that the resulting debt

accumulation would require future tax increase for servicing the debt. Thus the effects onthe consumption will be minimum. But history contains few Ricardian experiments in

which taxes are changed independently of other events which may simultaneously

influence consumption and savings2. Further, many of the empirical tests one might

conduct require strong assumptions about the nature of consumption function, interestrate and income expectations, and other features of economic parameters.

But literature reveals that both time-series and cross-section data indicate agenerally positive correlation between consumption and measures of government deficits.

The government deficits capture the intergenerational impact of tax policy imperfectly.

Nonetheless, some research studies suggest that current accounts might be negatively

related to government deficits that is similar to the results of overlapping generationmodel, and these two are not completely unrelated as claimed in Ricardian equivalence.

2 Although David Ricardo explained the theoretical arguments for equivalence in his bookPrinciples ofPolitical Economy and Taxation (1817), he did not believe that the results would be applied in practice. He

warned against the dangers of high public debt levels as he feared that labour and capital might migrate

abroad to avoid the taxed needed for servicing the national debt ( Ricardo, 1951; pp 247 249 ).

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