Open Economy Version Research Articles

The big push, industrialization and international trade: The role of exports

Abstract This paper analyzes the “late” industrializations of South Korea and Taiwan, and how they can be produced by an export promotion policy. The paper adopts an open economy version of the well-known big push model. Thus, it recovers neoclassical accounts of industrialization through exports, complementing previous literature, which tends to show the existence of the big push, but is scarce on trade mechanisms to produce it. The model fits well with some stylized facts of the industrializations in East and Southeast Asia. I also apply it to a comparison of the education policies of East Asia and Latin America.

Monetary Policy and Exchange Rate Volatility in a Small Open Economy

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to simple representation in domestic inflation and the output gap. We use the resulting framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.

Foreign Direct Investment and Productivity Growth: A Survey of Theory

This paper analyses several theoretical perspectives on the relationship between foreign direct investment (FDI) flows and 'productivity growth', interpreted as growth in total factor productivity (TFP). We begin with general equilibrium models. An open economy version of Solow's famous (1956) growth model is developed, where North-to-South FDI flows both equalize the return to capital across countries and transfer technical knowledge internationally. Two recent models of general equilibrium with imperfect competition are also discussed: one allows for specialisation in intermediates production a la Ethier (1982), and the other contains endogenous RD (b) trained worker mobility as a specific mechanism for spillovers; and (c) the relationship between FDI flows and RD and, second, when firms differ in their technologies).

IS-LM-BP: An Inquest

Open economy macroeconomics is not a new field of theoretical inquiry. Its origins can be traced back to mercantilist and classical notions of the impact of the trade balance, gold flows, and exchange rate mechanisms (e.g., Hume [1752] 1970). But formal mathematical and geometric models of trade and capital flows and exchange rate movements are a much more recent development, emerging only over the past seventy years. Roy Harrod and James Meade published early works, parts of which dealt with floating exchange rates and “free capital movements” (Harrod 1933, 1936; Meade 1936). This and subsequent work of Meade and Lloyd Metzler, among others, stimulated a generation of theorists to develop what Robert Mundell (2002) calls the “international macroeconomic model.” In previous work, we examined the development of the early mathematical models of IS-LM closed economy vintage (Darity and Young 1995). Here, we attempt to do the same for the open economy version of IS-LM. There are a number of general accounts of the evolution of the open economy model, including Kenen 1985, Flanders 1989, and Isard 1995, and specific accounts of the evolution of the “Mundell-Fleming model” (Blejer, Kahn, and Masson 1995; Boyer 2002; Boughton 2003),

High public debt in currency crises: fundamentals versus signaling effects

Abstract This paper examines how public debt, government credibility and external circumstances affect the probability of currency devaluations in a three-period, open-economy version of the Barro and Gordon (J. Polit. Economy 91 (1983) 589) model. Nominal public debt links current to future policy actions: resisting a crisis may either enhance or undermine the sustainability of the exchange rate regime depending on whether what matters is the government’s reputation or fundamentals, i.e. the level of the debt. The focus is on the impact of public debt, debt maturity and the government’s credibility on the expected devaluation in the current and future periods. We can thus identify the factors that affect the short-term interest rate and the forward rate, hence derive predictions about the level and the slope of the yield curve.

Monetary Policy and Exchange Rate Volatility in a Small Open Economy

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to simple representation in domestic inflation and the output gap. We use the resulting framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.

Quantifying the Second-Round Effects of Supply-Side Shocks on Inflation

This paper uses a small-scale dynamic rational expectations model based on an openeconomy version of Fuhrer-Moore-type staggered wage setting to quantify the secondround effects of selected supply-side shocks and of shocks to the nominal exchange rate on wages and subsequently on inflation. In order to analyse the desired reaction of the central bank to these shocks, optimal time-consistent policy rules are derived within the presented New-Keynesian framework. The conclusions presented in the paper suggest that the second-round effects of shocks to import prices and the nominal exchange rate on inflation should not be ignored in practical policy-making.

Accession trajectories and convergence: endogenous growth perspective

In this paper we analyze qualitatively and quantitatively the potential effect of the accession on the development of several Central and Eastern European (CEE) countries (specifically, the Czech Republic, Hungary, and Poland). To achieve the task we design an endogenous growth model of an accession economy with special features. Since we perceive the process of accession as progressive opening of the economy in terms of trade and capital flows, on the one hand, and as a massive technological transfer that enables fast technological catch-up with the technological frontier of the advanced countries, on the other, we build a small open economy version of the two-sector endogenous growth model of the Uzawa–Lucas style with knowledge diffusion. The model is first calibrated to stylized facts of the economic development during the accession process in the EU periphery countries. In general, the experience of the EU peripheral countries fits the predictions of our model reasonably well. Using alternative scenarios in several dimensions we then calibrate the model according to the data on the CEE countries above and simulate their behavior. The interplay of various initial conditions and the parameters of the accession generate different accession patterns and also rather different speeds of convergence to the EU average. The model outcomes do not only provide us with these quantitative estimates but also improve our understanding of the economic mechanisms, which underpin those transitions.

Monetary policy and the credit channel in an open economy

This paper extends Bernanke and Blinder's [Am. Econ. Rev. 78 (1988) 435] “credit-channel” model to the open economy. In particular, it examines whether the monetary policy results predicted by the popular textbook Mundell–Fleming model [e.g., Can. J. Econ. Polit. Sci. 29 (1963) 475; IMF Staff Pap. 9 (1962) 369] change with the open-economy version of the Bernanke and Blinder credit-channel model. This examination is important to consider in light of the popularity of the Mundell–Fleming model at the policymaking level and in light of recent empirical findings giving strong support to the credit channel as a monetary policy transmission mechanism. The main conclusion is that monetary policy is much more potent under the open-economy version of the Bernanke and Blinder model than under the standard Mundell–Fleming model.

The BMW Model: Simple Macroeconomics for Closed and Open Economies - A Requiem for the IS/LM-AS/AD and the Mundell-Fleming Model

While the IS/LM-AS/AD model is still the central tool of macroeconomic teaching in most macroeconomic textbooks, it has been criticised by several economists. Colander [1995] has demonstrated that the framework is logically inconsistent, Romer [2000] has shown that it is unable to deal with a monetary policy that uses the interest rate as its operating target, Walsh [2001] has criticised that it is not well suited for an analysis of inflation targeting. In our paper we start with a short discussion of the main flaws of the IS/LM-AS/AD model. We present the BMW model as an alternative framework, which develops the Romer approach into a very simple, but comprehensive macroeconomic model. In spite of its simplicity it can deal with issues like inflation targeting, monetary policy rules, and central bank credibility. We extend the model to an open-economy version as a powerful alternative to the IS/LM-based Mundell-Fleming (MF) model. The main advantage of the open-economy BMW model is its ability to discuss the role of inflation and the determination of flexible exchange rates while the MF model is based on fixed prices and constant exchange rates. This working paper is an extended and more theoretical version of Wurzburg Economic Paper No. 34. Besides describing the derivation of optimal interest rate rules and the concept of loss functions more in detail, it also discusses simple interest rate rules in an open economy as well as a strategy of managed floating within the same theoretical framework. Additionally, we explore the stabilizing properties of simple interest rate rules.

The BMW Model: A New Framework for Teaching Monetary Macroeconomics in Closed and Open Economies

While the IS/LM-AS/AD model is still the central tool of macroeconomic teaching it has been criticised by several economists. The model is unable to deal with a monetary policy that uses the interest rate as its operating target ( Romer [2000]). Walsh [2002] has criticised that it is not suited for an analysis of inflation targeting. We present the BMW model as an alternative framework, which develops the Romer approach into a simple macroeconomic model. It can deal with issues like inflation targeting, monetary policy rules, and central bank credibility. Our open-economy version is a powerful alternative to the IS/LM-based Mundell-Fleming (MF) model. The main advantage of the open-economy BMW model is its ability to discuss the role of inflation and the determination of flexible exchange rates while the MF model is based on fixed prices and constant exchange rates.

Indeterminacy in a Small Open Economy Ramsey Growth Model

This paper presents a small open economy version of the J. Benhabib and R. E. A. Farmer (1996, J. Monet. Econ. 37 , 421–443) two sector optimal growth model with production externalities. It is shown that indeterminacy is considerably easier to obtain under a regime of perfect world capital markets than in the closed economy variant. Furthermore, the result is not dependent on a high labor supply elasticity since that input is fixed. The paper also examines a variant which takes into account external borrowing constraints and it is shown that the qualitative results on indeterminacy remain basically unaffected by this extension. Journal of Economic Literature Classification Numbers: E32, F12.

Capital mobility in the world economy: an alternative test

Abstract This paper proposes a new measure and test of international capital mobility. In order to investigate capital flows, we utilize a small open economy version of Campbell and Mankiw's [NBER Macroeconomic Annual (1989) 185–216] permanent income model. Our capital mobility measure focuses on the correlation between the country's consumption and net output instead of the correlation between domestic saving and domestic investment proposed by Feldstein and Horioka [Economic Journal 90 (1980) 314–329]. The model is estimated for 11 OECD countries. The results suggest that the null hypothesis of perfect capital mobility cannot be rejected for more than a half of these countries. On the other hand, some kind of capital mobility constraints are detected for several countries including the United States and Japan.

External debt and Ponzi-games in a small open economy with endogenous growth

This paper analyses the effect of external government borrowing in a small open economy version of the Diamond model with endogenous growth. Contrary to earlier results from the closed economy version of this model, Ponzi-games are growth- and welfare-enhancing. Intuitively, the growth rate of the economy works as the planner's time discount factor. If a country can borrow at a rate less than this, it will increase welfare for all generations except the initially old generation whose welfare is unchanged.

Financial Fragility and the Exchange Rate Regime

We study financial fragility, exchange rate crises, and monetary policy in an open economy version of a Diamond-Dybvig model. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks become possible. We compare currency boards, fixed rates, and flexible rates with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, bank runs are possible under a currency board. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. A flexible rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies are appropriately designed.

Real Interest Differentials and Macro Fundamentals: Empirical Estimates

This paper explores the implications of an open-economy version of the Lucas asset pricing model for the empirical relationship between pairwise real interest rate differentials and macroeconomic fundamentals for the United States, West Germany, and the United Kingdom from 1974 to 1989. Using Hansen's Generalized Method of Moments, the model's overidentifying restrictions cannot be rejected, while exclusion restrictions on the effect of fluctuations in money and output growth rates on real interest differentials are rejected in the majority of cases. These results are encouraging for those who believe that structural models driven by fundamental macroeconomic variables can help explain price determination in international financial markets.

Real Interest Differentials and Macro Fundamentals: Empirical Estimates

This paper explores the implications of an open-economy version of the Lucas asset pricing model for the empirical relationship between pairwise real interest rate differentials and macroeconomic fundamentals for the United States, West Germany, and the United Kingdom from 1974 to 1989. Using Hansen's Generalized Method of Moments, the model's overidentifying restrictions cannot be rejected, while exclusion restrictions on the effect of fluctuations in money and output growth rates on real interest differentials are rejected in the majority of cases. These results are encouraging for those who believe that structural models driven by fundamental macroeconomic variables can help explain price determination in international financial markets.

Liquidity and real activity in a simple open economy model

Abstract This paper analyzes the ability of an open-economy version of Lucas's (1990) liquidity model to account for properties of international data. The focus is on the model's ability to account for exchange rate dynamics and measured effects of monetary policy shocks on exchange rates, interest rates, and real activities across countries. The model generates a prediction that a positive domestic monetary innovation is associated with nominal and real currency depreciations. However, the model's predictions with respect to nominal and real exchange rate volatilities are low.

Conditional Relative Price Variance and Its Determinants: Open Economy Evidence from Germany

The authors present empirical tests of two hypothesis derived from an open economy version of the multimarket equilibrium model. The first hypothesis holds that the conditional relative price variance is positively related to the variance of domestic monetary and foreign nominal and real shocks. The second hypothesis claims a negative impact of an increase in conditional relative price variance on normal output. In contrast to earlier studies, the authors use direct measures of conditional relative price variance based on ARCH estimates. The authors' results show that both hypotheses are consistent with German data. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Some macroeconomic effects of nationalizing private sector foreign debt

In the recent debt crisis years, many governments have adopted foreign debts of their domestic private sectors. This paper uses a simple small open economy version of Blanchard's (1985) overlapping generations model to demonstrate that such a policy encourages the accumulation of national foreign debt and can contribute to higher inflation. Because individuals have finite lives they fail to fully internalize the government's intertemporal budget constraint. Current generations therefore regard the debt relief as an increase in wealth. They raise consumption which causes current account deficits. Future generations have to lower consumption to service the additional debt. The debt service takes the form of a higher inflation tax. If the government tries to stabilize exchange rates while nationalizing debt, both the debt and inflation problems are exacerbated.