An Open Economy Dynamic General Equilibrium Model Linking the Euro Area and the US Economy

Abstract

Over the last decade, the ‘New Open Economy Model’ (NOEM) has become the standard model to analyse the behaviour of the exchange rate and the current account. This model is based on the optimising behaviour of the microeconomic units, firms and households, in a monopolistic competitive environment with nominal rigidities in the price and wage setting. Consumption and investment goods are aggregate baskets of domestic and foreign goods, which are considered as imperfect substitutes. Demand is allocated between these goods based on the real exchange rate. The current account is consistently explained by the intertemporal decisions on the one hand, that is the savings minus investment identity, and the intratemporal decisions, that is the allocation of demand depending on the relative price of the domestic and foreign goods, on the other hand. The exchange rate is determined by the uncovered interest rate parity condition. In the literature, these models have been used intensively to discuss the issue of optimal monetary policy and of international policy co-ordination.