Propagation of Nominal Shocks in Open Economies

Abstract

Empirical evidence documents substantial persistence in the adjustment process to nominal shocks. Existing open‐economy models either have failed to generate interesting dynamics or have found that the mechanisms are quantitatively weak. We consider the propagation of nominal shocks in a fully specified stochastic intertemporal open‐economy model with incomplete capital markets and staggered nominal wage contracts. It is shown that persistence depends on wage–price interdependences (spiral), which in turn in a general equilibrium setting depend on structural parameters characterizing both the demand and the supply side of markets. Parameter choices strengthening wage–price interdependences thus strengthen persistence as is demonstrated analytically and illustrated numerically. A further product of the paper is that it develops a method by which to solve explicitly for a stochastic intertemporal version of the ‘new open‐economy macroeconomics’ model in which the expenditure switching effect is effective.