Obstfeld, Maurice. "International Macroeconomics: Beyond the Mundell-Fleming Model." International Monetary Fund Staff Papers. Special Issue, 2001

7/27/2019 Obstfeld, Maurice. "International Macroeconomics: Beyond the Mundell-Fleming Model." International Monetary Fund Staff Papers. Special Issue, 2001.

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fore should be interpreted as my own, somewhat impressionistic, view. A

testament to the lasting in

uence of their work is that much of the discus-sion can be framed with reference to what Fleming and especially Mundellaccomplished in their work of the 1960s and 1970sand left undone. 2

The discussion is organized as follows. Section I focuses on postwaradvances, discussing how, successively, the work of Mundell and Feming,the monetary approach to the balance of payments, and the intertemporalapproach to the current account placed international capital mobility anddynamics at center stage in open-economy macromodels. Section II is anoverview on the behavior of international prices, and the strong evidence thatprices are sticky in nominal terms and that international markets for trad-able goods remain highly segmented. Section III discusses newer modelingapproaches that reconcile the breakthroughs in dynamic open-economy the-ory through the 1980s with the sticky-price setup pioneered by Mundell andFleming. The section includes a rather detailed example of a stochastic newopen economy macroeconomics model in which the expenditure-switchingeff ects of exchange rates central to the Mundell-Fleming model coexists withextreme market segmentation for tradable consumption goods and pricingto market. This class of models allows us to address rigorously, for the rsttime, a number of classic issues that have long been central to informal policydiscussions in international macroeconomics.

1 Disequilibrium, Capital M obility, Dynam-ics

The Classical paradigm that dominated international macroeconomic think-ing until the First World War depicted a self-regulating global economy. The

2The postwar period is coterminous with the history of the International MonetaryFund, and it is no accident that a number of important postwar intellectual developmentsincluding, among others, contributions by Mundell and Flemingoriginated in the re-search functions of the Fund. In this paper, however, I will not attempt systematically toreview research done by the Fund or by any other institution. Retrospective evaluations of

Fund research can be found in Blejer, Khan, and Masson (1995) and Polak (1995). I willfocus on nuts-and-bolts modeling of open-economy macro structure and policy e ff ects, tothe exclusion of the very interesting work done in recent years on regime switches, policycredibility, and the like. Even my discussion of macro-structure will be partial, as I willhave space only to mention in passing research on international asset pricing and on thediff erent functions of international capital ows.

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Classical world is a stable dynamical system in which adjustment of national

price levels and the free

ow of specie can be relied upon to restore swiftlyboth full employment and equilibrium in national balances of payments. Thispicture of near-frictionless adjustment, with sovereign economic interventionslimited by rules of the game, is a gross exaggeration even of the conditionsexisting under the Victorian Pax Britannica . But the Classical paradigm,despite its positive shortcomings, serves as a useful theoretical benchmark.And it reminds us that dynamic considerations have been at the heart of international macroeconomics at least since the days of Gervaise and Hume.

During the interwar period, extreme economic dislocations promoted anoverly idyllic view of prewar conditions. These dislocations included nation-alistic measures that sharply reduced economic integration among countries: at monies trading at oating exchange rates, preferential trade arrange-ments, direct state trading, default on foreign debts, and exchange controls.In earlier years economists had regarded such nationalistic experiments, whenthey occurred in Latin America or other area of the periphery, with a mixtureof fascination and disgust. 3 Now, however, similar economic arrangementswere painfully relevant among the advanced countries themselves. The Clas-sical paradigm had become largely irrelevant to actual international con-ditions. Moreover, it could not explain the economic cataclysm that hadbrought those conditions into being.

1.1 K eynesian A pproaches: From M etzler and M achlupto M undell

The stage was set for Keyness revolution and for the adaptation of itscentral ideas to international questions at the hands of Metzler, Machlup,and others. The new models they developed dealt with an essentially staticworld characterized by rigid wages and prices, unemployment, and limited nancial linkages between countries. Key contributions elucidated the e ff ectsof trading relations on Keynesian multipliers, international repercussions, theeff ects of devaluation, the determination of oating exchange rates, and therole of the terms of trade in the Keynesian consumption function. The role of monetary factors, so central to the Classical approach, was down-played if notignored. Metzlers (1948) survey for the American Economic Association wasquite explicit in repudiating the central role which [the classical mechanism]

3The apt phrase is due to Bacha and Daz-Alejandro (1982).

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attributes to the monetary system (p. 212). However, the new approach

gave no guide to the alternative mechanisms that would eliminate externalimbalances over time, and implicit assumed instead that sterilization policiescould be followed inde nitely. 4

Meades magisterial treatise The Balance of Payments (1951), publishedexactly a half-century ago, attempted to embed the Keynesian developmentswithin a much broader framework that also embraced monetary factors.Meades book is remarkable both in its ambitions and in its accomplishments.It summarized and (to a lesser extent) synthesized international monetarythinking as it had developed over the centuries. Meade sought to presenta systematic account of economic problems and their solutions in an openeconomy, entertaining a wide variety of assumptions on price exibility andinternational payments arrangements with the goal of guiding policy choice.In so doing, he discovered much that would be rediscovered later and set alarge portion of the research agenda for the subsequent decades.

Indeed, it became fashionable for a time to dismiss much of subsequentinternational economic research with the remark Its all in Meadeanassertion di ffi cult to refute given the works nearly impenetrable expositorystyle. The forbidding facade, however, repelled would-be readers and greatlyreduced its impact. Mundell (1968, p. 113) rated the work as a landmarkin the theory of international trade and economic theory in general, muchunderestimated by contemporary reviewers, but he lamented the defects of

its organization and presentation.Meade himself (1951, p. viii) pointed to one major gap in his theoreticaltreatment of international macroeconomics:

But I must confess frankly that there is one piece of mod-ern technique in economic analysis which is very relevant to theproblems discussed in this volume, but of which I have made nouse. I refer to the analysis of the dynamic process of change fromone position of equilibrium to another. The method employed inthis volume is rst to consider a number of countries in at leastpartial or temporary equilibrium, domestically and internation-

ally; then to consider the new partial or temporary equilibriumwhich the economies will attain when the direct and indirect ef-fects of the disturbing factor have fully worked themselves out;

4For further discussion, see Obstfeld (1987).

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and nally to compare the new position of equilibrium with the

old. In other words, this is a work not on dynamics, but oncomparative statics, in economics.

Meade criticized the lack of any explicit mathematical account of howthe economy gets from one partial or temporary equilibrium to another.A related problem, already noted above and highlighted by Meades partialor temporary quali er, was even more fundamental to much of the Key-nesian theorizing of the 1940s and 1950s. Situations of external imbalancenecessarily imply that stocks of domestic wealthmoney and perhaps otherassetsare not stationary, and, thus, that the economys temporary equi-librium must evolve over time, even in the absence of exogenous impulses.

But what intrinsic dynamics would operate in a world seemingly at oddswith the assumptions driving Humes analysis of the economys movementtoward a long-run equilibrium? In particular, would this dynamical processbe a stable one, and how would its nature depend on the activist economicpolicies that might be in play? Despite Alexanders important formulationof the absorption approach in the early 1950s (Alexander 1952), an approachthat brought to the fore the role of desired wealth changes in generatinginternational imbalances, surprisingly little progress on these questions wasmade until Mundells work in the early 1960s.

In a path-breaking series of articles, Mundell took up the challenge of lling the gap that Meades omission of dynamics had left. By so doing, hereintroduced the idea of a self-regulating adjustment mechanism that hadbeen central to the Classical framework. In line with the evolution of world nancial markets since Meades book, Mundell put international capital owsat center stage in his dynamic analysis. Had his achievement been entirelytechnical, it might have had little impact. Instead, through a rare combina-tion of analytical power and Schumpeterian vision, Mundell distilled fromhis mathematical formulations important lessons that permanently changedthe way we think about the open economy.

Mundell followed Meade in emphasizing the monetary sector, using aliquidity-preference theory of money demand to tie down the short-run equi-

librium. Metzler (1968), in work done around the same time, took a similartack, but he was less successful, whether his work is judged by its theoreticalelegance or immediate policy relevance. Fleming (1962), working in paral-lel, developed a model quite similar to Mundells basic short-run equilibriumframework, and the two justly share credit for this contribution. Fleming did

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not, however, formally address the long-term adjustment process implicit in

Keynesian models, con

ning himself to some prescient remarks on the longversus short-term responsiveness of the capital account.Mundell focused squarely on the dynamic e ff ects of payments imbalances

in his paper on The International Disequilibrium System (Mundell 1961a).Even in a world of rigid prices, Mundell argued, an income-specie- ow mech-anism analogous to Humes price-specie- ow mechanism ensures long-runequilibrium in international payments. An increase in a countrys moneysupply, for example, would depress its interest rate, raise spending, and openan external de cit that would be settled, in part, through money out owsFor a small economy, the end process would come only when the initialequilibrium had been re-established. Mundell clari ed the role of steriliza-tion operation, showing that they can be at best a temporary response topermanent disturbances a ff ecting the balance of payments. This work wasin uential in indicating the ubiquity of self-regulating mechanisms of interna-tional adjustment, and, as a corollary, the limited scope for monetary policywith a xed exchange rate, even under Keynesian conditions. 5

While Mundells disequilibrium system argument (1961a) showed howthe income-specie- ow mechanism would restore balance-of-payments equi-librium under Keynesian conditions, the analysis did not delineate automaticforces tending to restore full employment (internal equilibrium). To addressthat issue, Mundell pursued the idea of a policy mix in which scal policy

would play a central role. Mundell (1962) applied a dynamic approach to the joint use of monetary and scal policy to attain internal and external targetsunder a xed exchange rate. He showed that under capital mobility, pol-icy dilemma situations that might arise under xed exchange rates could besolved. Mundell showed that by gearing monetary policy to external balance(de ned as a zero offi cial settlements balance) and scal policy to internalbalance (full employment), governments could avoid having to trade o ff in-ternal against external goals in the short run. The key to his argument wasthe claim that monetary and scal expansion both raise output but have op-posite eff ects on interest rates. Thus, for example, a country simultaneouslyexperiencing unemployment and an external de cit could couple scal expan-

sion with monetary contraction in a way that lifts aggregate demand while5Of course earlier writers, such as Keynes (1930, p. 309), had recognized some of

the limitations that xed exchange rates and capital mobility place on national monetarypolicies.

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balance-of-payments equilibrium through a permanently higher interest rate.

The results of such a policycrowding out of domestic investment and anongoing buildup of external debtwould eventually call for a sharp drop inconsumption. 6 While Mundells framework was perhaps useful for thinkingabout very short-run issues (such as the need to maintain adequate nationalliquidity), it failed completely to bridge the gap from the short run to thelonger term.

Indeed, the theory of the policy mix had little practical signi cance underthe Bretton Woods. In his detailed study of nine industrial countries policiesduring the postwar period to the mid-1960s Michaely (1971, p. 33) foundonly two episodes in which the prescription of the Mundellian policy mix wasconsistent with the o ffi cial measures authorities actually took. Most of thetime, Michaely concluded, scal policy simply was excluded from the list of available instruments. 7

1.2 Classicism R edux: M onetary and P ortfolio A p-proaches

By the mid-1960s, Mundells dissatisfaction with his own early rendition of monetary dynamics led him to pursue the monetary approach to the bal-ance of payments . The approach is also associated, in di ff ering forms, withHarry G. Johnson and with the IMFs Research Department under Jacques

J. Polak.8

If one thought of the University of Chicago style of monetaryapproach as being primarily a retrogression to the Classical paradigm, onemight reckon its intellectual impact as being rather transitory. I think thatconclusion would be wrong, however, and that the monetary approach in real-ity made three enduring contributions. Along with research of the late 1960son closed-economy models of money and growth, it helped drive home to the

6Meade (1951, p. 104n) recognized clearly that in choosing between monetary and scal policy, [t]he question of the optimum rate of saving is involved. Mundell brie ydiscusses problems of the composition of the balance of payments in chapter 10 of his1968 book, likening them to problems of the proper division of national product betweenconsumption and saving. Purvis (1985) includes a nice discussion of scal de cits and

the external debt burden from the perspectives of the Mundell-Fleming and subsequentmodels.7For a more detailed discussion of practical problems in deploying scal policy, see

Obstfeld (1993).8See Frenkel and Johnson (1976) and International Monetary Fund (1977). For a

perspective on alternative interpretations of the monetary approach, see Polak (2000).

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profession key distinctions between stocks and ows in dynamic international

macroeconomic analysis. Furthermore, it provided a set of consistent long-run models that, aside from their intrinsic theoretical interest, could serve asbenchmarks for more realistic analyses. Finally, with its formal elegance andthe extravagance of its claims, the monetary approach breathed new life andbrought new blood into a eld that was becoming a bit tired.

I argued earlier that Mundells treatment of capital ows in his work onthe policy mix emphasized the monetary component of wealth at the expenseof other forms, notably net external assets. As a result, the distinctionbetween stock equilibrium in asset markets and ow equilibrium in outputand factor markets was blurred. These failings would have appeared evenmore glaring had Mundells models of the early 1960s been applied to longer-term issues, rather than to the short-run Keynesian stabilization questionsfor which they were designed. Mundell presumably intended to include hisown earlier work when he remarked, in his Barter Theory and the MonetaryMechanism of Adjustment (Mundell 1968, chapter 8, p. 112):

Innovations in the eld since the 1930s have stressed the applica-tion of Keynesian economic concepts to the international sphere,rather than the integration of Keynesian international economicswith classical barter theory or classical international monetaryeconomics, creating a weakness in the area.

Indeed, the model Mundell developed here as a start on the problemdid allow for sticky domestic prices, slowly adjusting to a carefully speci- ed underlying Classical equilibrium. Later work, both by Mundell and hisstudents at Chicago, was to take the Classical assumptions more literally;see, for example, Mundell (1971). Although most of the work of the mone-tary approach school over-simpli ed wildly in abstracting from assets otherthan money, a major attention, as noted above, was the careful attentionpaid to the equilibrating role of output and factor prices in the transitionfrom temporary to long-run equilibrium. While the approach lacked real-ism, it clari ed the precise mechanics of Humean international adjustment,

demonstrated the longer-run links between growth and the balance of pay-ments, and showed how a focus on money supply and demand could help oneto quickly ascertain the balance-of-payments e ff ects of various disturbances.However, due to the ongoing growth of world nancial markets, the appropri-ateness of relying on the balance-of-payments money account as an indicator

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of external balance was becoming increasingly questionable as the monetary

approach developed, especially for industrial countries with ready access toworld capital markets.Models incorporating a broader spectrum of assets were being developed

concurrently. McKinnon and Oates (1966) is an early attempt along theselines, as is chapter 9 of Mundell (1968). Tobins (1969) seminal contributionto monetary theory set o ff a surge of research on multi-asset portfolio-balancemodels better equipped than those of the monetary school to describe in-ternational adjustment in a world of mobile capital. Foley and Sidrauskis(1971) elegant dynamic closed-economy rendition of the portfolio-balanceapproach provided a model for intertemporal applications in open-economysettings. The monetary and portfolio-balance approaches essentially mergedin the mid-1970s, producing useful descriptive models of the long-run adjustment of monetary ows, current accounts, goods prices, and, somewhatlater, of oating exchange rates. 9 Following Blacks (1973) lead, many of these oating-rate models took from macroeconomics proper the then-novelmodeling assumption of exchange-rate expectations that are rational , that is,consistent with the economys underlying structure (including the statisticaldistribution of the relevant exogenous forces). Of course, the rational expec-tations assumption also gured prominently in the many extensions of theMundell-Fleming framework that continued to be fruitfully pursued, start-ing with Dornbuschs (1976) landmark overshooting version of Mundell-

Fleming, which incorporated output-price, but not wealth, dynamics.These modern exchange rate models share a view of the exchange rateas an asset price (the relative price of two currencies), determined so as toinduce investors willingly to hold existing outside stocks of the various assetsavailable in the world economy. Mussa (1976) o ff ers what is perhaps the clas-sic exposition of this asset view of exchange rate determination. The enduringinsight of the exchange rates asset-price nature was obscured in versions of the Mundell-Fleming model that modeled the capital account analogously to

9For a more detailed discussion, see Obstfeld and Stockman (1985). A notable intel-lectual landmark here is the May 1976 conference issue of the Scandinavian Journal of Economics . The monetary approach to exchange rate determination is one strand in this

literature; generally that approach builds upon a version of the exible-price monetarymodel in which the law of one price holds and money supplies rather than exchange ratesare exogenous while exchange rates rather than money supplies adjusts to equilibrate si-multaneously the goods and asset markets. See, for example, the essays in Frenkel andJohnson (1978).

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the current account, as a ow function of the level relative interest rates. By

postulating that the exchange rate is determined by the condition of a zeronet balance of payments, those models missed the exchange rates role in rec-onciling stock demands and supplies that are normally orders of magnitudegreater than balance of payments ows. Thus, the Mundell-Fleming model,in its earlier incarnations, o ff ered no account of high exchange rate volatility.

1.3 I ntertemporal Approaches to the Current A ccountA nal important branch in these dynamic developments was the applicationof optimal growth theory, in the style of Ramsey, Cass, and Koopmans, toopen economies. Notable contributions along these lines were made early onby Bardhan (1967), Hamada (1969), and Bruno (1970).

Building on these approach in the early 1980s, a number of researchersdeveloped an intertemporal approach to the current account in which sav-ing and investment levels represent optimal forward-looking decisions. 10 Thenew approach contrasted with the Keynesian approaches in which net ex-ports are determined largely by current relative income levels and net for-eign interest payments are, for the most part, ignored. These new models,unlike the earlier open-economy growth models, were applied to throw lighton short-run dynamic issuessuch as the dynamic e ff ects of temporary andpermanent terms-of-trade shocksand not just the transition to a long-runbalanced growth path. They could also be used to think rigorously aboutnational intertemporal budget constraints, government intertemporal budgetconstraints.

The intertemporal approach, unlike the Keynesian or monetary approachesprovided a conceptual framework appropriate for thinking about the impor-tant and interrelated policy issues of external balance, external sustainability,and equilibrium real exchange rates (for a recent example, see Montiel 1999).All of these concepts are intimately connected with the intertemporal trade-off s that an economy faces. Another major advantage of the intertemporalapproach was its promise of a rigorous welfare analysis of policies in openeconomiesan analysis on a par, in rigor, with those already applied rou-

tinely to intertemporal tax questions. The approach shifts attention fromautomatic adjustment mechanisms and dynamic stability considerations tointertemporal budget constraints and transversality conditions for maximiza-

10 For a more extensive survey of the area see Obstfeld and Rogo ff (1995a).

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tion, although those perspectives may well, of course, be mutually consistent.

2 M odels versus R ealityLike the monetary approaches to the balance of payments and to exchangerates, the intertemporal mode of current account analysis developed in the1980s generally assumed perfectly exible domestic prices. It thereby ab-stracted from short-run price rigidities and the concomitant disequilibria ingoods and factor markets: the issues at the heart of the Mundell-Flemingmodel and its successors, such as the Dornbusch model, were simply putaside. The monetary and intertemporal models also, in general, assumed a

rather high degree of economic integration among the economies being mod-eled. Presumably, a high level of integration among economies might justifyabstraction from price rigidities, since these could not survive long in theface of international goods arbitrage.

Was this level of abstraction justi ed? In a well-known paper writtenafter nearly a decade of oating exchange rates, McKinnon (1981) arguedthat the world economy had moved far away from the insular economicpattern of the 1950s and 1960s, in which countries carried out some foreigntrade but were otherwise largely closed to external in uences. In the newworld of more open economies, the earlier Keynesian (and elasticities) ap-proach to open-economy macroeconomic questions had become outmoded.Instead, the type of assumption underlying the monetary approachhighlyopen economies with goods and capital markets open to the forces of interna-tional competitionwas a better approximation to reality. 11 Twenty yearsfurther on in the process of postwar globalization, shouldnt the McKinnonarguments, if true when they were advanced, carry even greater force?

2.1 Evidence on InsularityThe answer that seems to come resoundingly from the data is No. Even to-day, the worlds large industrial economies (along with many smaller economies)remain surprisingly insular, to use McKinnons term. McKinnon rightly iden-ti ed a trend of increasing openness, but jumped the gun in declaring the

11 McKinnon di ff ered from the monetary approach in questioning the existence of a stablenational money demand function, in the absence of which, he argued, xed exchange rateswere preferable to oating rates.

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age of insularity to be over.

There are several well-known manifestations of .persistent insularity. Formany goods, transport costs are su ffi ciently high that a fairly large proportionof GDP can be considered e ff ectively nontradable. But as Meade (1951,p. 232) pointed out in an even more insular era, nontradability is only anextreme consequence of trade costs, which attach to all goods to varyingdegrees:

Products range with almost continuous variation between thosefor which the cost of transport is negligibly low in relation to theirvalue and those for which the costs of transport are so high as tobe in all imaginable circumstances prohibitive.

One consequence of pervasive transport costs (and other costs of tradesuch as offi cial impediments) is the existence of a fairly sizable transfereff ect due to changes in countries net foreign assets. 12 This transfer e ff ectcan be seen both in countries terms of trade and in their real exchangerates. Regarding the latter, Lane and Milesi-Ferretti (2000), using the mostcomprehensive cross-country panel on national net foreign asset positionsdeveloped to date, estimate that a 50 percent of GDP fall in a countrysnet foreign asset position (corresponding, perhaps, to a 2 percent of GDPfall in the long-run current account balance) would be associated with a 16percent real currency depreciation. They nd that this e ff ect is potentially

much larger for bigger and less open economies. In addition, we see fairlylarge home biases in consumption and trade. Of course, standard versions of the Mundell-Fleming model assume a transfer e ff ect arising from (generallyunexplained) home consumption preference.

We also observe puzzling symptoms of capital-market segmentation, no-tably, the Feldstein-Horioka cross-section correlation of saving and invest-ment and the home bias in equity portfolios. While imperfections intrinsicto capital markets partly lie behind these capital-market puzzles, costs of trade in goods can go a long way in generating insular capital-market be-havior, as argued by Obstfeld and Rogo ff (2000b).

Some of the most dramatic evidence on insularitycertainly the hard-est to rationalize in terms of internationally divergent consumer tastes or

12 See Mundell (1991) for a discussion of theory relating to the transfer problem. AsMundell points out, even with nontradable goods, there need be no transfer problemsee also chapter 4 in Obstfeld and Rogo ff (1996) for a model along these lines. But thepreconditions for this result are very stringent and unrealistic.

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exceptions seem to be episodes in which domestic in ation is extremely high,

in which case prices, like the exchange rate, come unhinged and the corre-lation between real and nominal exchange rate changes drops (see Obstfeld1998).

The Mussa results also have a bearing on hypotheses about cross-bordergoods market integration. If arbitrage works strongly to keep internationalgoods prices in line, then very large real exchange rate uctuations would beruled out. At the very least, large uctuations would be rather temporary, aspro t maximizing traders quickly move to reap extra-normal pro ts, drivingreal exchange rates back into line. In fact, the evidence contradicts this ideaas well. As shown by many, many studies (see Rogo ff 1996 for a survey), realexchange rate movements are highly persistent, so much so that it has beendiffi cult to reject the statistical hypothesis that real exchange rate processescontain unit rootsa violation of even a weak form of long-run purchasingpower parity that allows for deterministic trends. The best current esti-mates of real exchange rate persistence suggest that under oating nominalexchange rate regimes, the half-lives of real exchange rates innovations rangefrom 2 to 4.5 years.

Such macro-level evidence may not be viewed as entirely convincing. Forone thing, real exchange rates are calculated with respect to the overall CPIincluding nontradables (or some other comparably broad price index). Thus,it could be the case that there is actually a considerable degree of arbitrage

among the most tradable goods entering these price indexes. Furthermore,there is the theoretical possibility that much of the persistence in real ex-change rates is due to real shocks, shocks that alter international relativeprices permanently without necessarily creating opportunities for arbitrage.Work based on disaggregated price data for CPI components, however, sug-gests that both of these hypotheses are not very relevant. As Engel (1993)shows, Mussa-style results also hold for international comparisons of the con-sumer prices of similar tradable goods. Regarding real shocks as a source of persistence in real exchange rates, it is much harder to argue that real shocksare responsible for changes in the relative international prices of very simi-lar, supposedly tradable goods. Yet movements in these relative prices are

just as persistent as movements in real exchange rates. Rogers and Jenkins(1995), for example, perform unit root tests on the relative United States-Canada prices of 54 narrowly de ned categories of goods and services. They nd that they can reject the null hypothesis of a unit root at the 10 percentlevel for only eight of the 54 categories (all food products). But even for

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food products, not all relative prices seem to be detectably mean reverting.

Obstfeld and Taylor (1997) document similar persistence at a disaggregatedlevel. This, it seems to me, is persuasive evidence against the theory that realshocks are the main source of real exchange rate persistence. What recurrentreal shocks do we imagine would be bu ff eting the relative supermarket priceof Canadian and United States our? The weight of evidence suggests thatwhatever factors allow the LOOP deviations documented by Isard (1977)and many others also lie behind the big and persistent swings in countriesreal exchange rates.

2.3 A ccounting for R eal Exchange R ate Changes

In recent important work, Engel (1999) o ff ers a striking way of illustrating just how pervasive the segmentation between countries consumer marketsis. Engel suggests decomposing a CPI real exchange rate change into (1)the component due to changes in international di ff erences in two countriesrelative prices of nontradable to tradable goods and (2) the component dueto changes in the countries relative consumer price of tradables. 14 Underclassic theories of the real exchange rate determination, such as the Harrod-Balassa-Samuelson account (see Obstfeld and Rogo ff , chapter 4), tradablesas a category closely obey the LOOP and so all variability in real exchangerates is attributable to factor (1) above. Engels work shows that the op-posite is true for real exchange rates against the United States. Even forreal exchange rate changes over fairly long horizons, nearly all variability canbe attributed to component (2), the relative consumer prices of tradables.This is a striking contradiction of the Harrod-Balassa-Samuelson theory. In-ternational divergences in the relative consumer price of tradables are sohuge that the theoretical distinction between supposedly arbitraged tradablesprices and completely sheltered nontradables prices o ff ers little or no help inunderstanding U.S. real exchange rate movements, even at long horizons.Apparently, consumer markets for tradables are just about as segmentedinternationally as consumer markets for nontradables. 15

14 As Engel (1999) explains, this is not an orthogonal decomposition. However, I do notbelieve that issue is central in interpreting his results, and I henceforth follow Engel inleaving it aside. Rogers and Jenkins (1995) earlier provided extensive evidence pointingto the same kinds of results that Engel emphasizes.

15 Of course, the results are subject to the caveat made above that tradability is amatter of degree. Notwithstanding that fact, one can still view them as evidence that

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Engels ndings can be summarized by graphs such as Figures 1-4. These

gures are based on monthly 1973-95 data from Engel (1999, section I).They show bilateral comparisons based on three oating exchange rates, dol-lar/yen, dollar/F-franc, and D-mark/C-dollar. Let E denote the nominalexchange rate, P the overall CPI, and P T and P N respectively, the CPIs fortradables and nontradables 16 In Figures 1-4, the behavior of the overall CPI-based real exchange rate, Q = E P /P , is compared with that of the tradableand nontradable real exchange rates, E P t /P t and E P n /P n . Each panel showsa plot against time, t, of the correlation between t-period percentage changesin the two variables shown.

As suggested by Engels ndings, the data reveal no signi cant di ff erencebetween short-term and long-term correlations, consistent with the hypoth-esis that mean reversion in the relative international price of consumer trad-ables is extremely slow. Strikingly, it seems not to matter much whethertradables or nontradables are used to compute real exchange rates. Indeed,it is remarkable that relative tradables prices consistently tend to displaya higher correlation with real exchange rates than do relative nontradablesprices, though the discrepancies are small and statistically insigni cant. Forthe countries shown, the behavior of relative international tradables prices isso similar to that of relative international nontradables prices, even for hori-zons out to ve years, that one is led to question whether the distinction iseven meaningful in discussing how real exchange rates behave under oating.

At the consumer level, one sees no evidence here of greater cross-border pricecoherence for tradables.High exchange rate volatility is what makes the preceding results so dra-

matic. Given the sluggish behavior of nominal consumer prices and the lackof operational arbitrage between consumer markets, the behavior of nominalexchange rates dominates these data. The role of exchange-rate volatilityin masking domestic relative price movements is illustrated in Figures 5-7,which use the monthly 1972-97 data from section IV of Engel (1999), inwhich the producer price index (PPI) is used to proxy the price of tradables.The gures are constructed as follows. For horizons t = 1 through t = 18 ,

goods commonly considered to be tradable due to relatively low transport costs appearto be not very tradable at all if they are de ned to include the services that bring themfrom the point of production to the consumer.

16 Engel (1999, appendix A) outlines his methodology for constructing the CPIsubindexes. Engels tradables comprise the OECDs all good less food and food,his nontradables, services less rent and rent.

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I average the mean squared error (MSE) of the 18 t-period changes in the

traded goods component of the CPI, log(E P P I /PPI ), each expressedas a fraction of the MSE of the t-period change in log Q. The resulting ratios,measured by the vertical axes of Figures 5-7, are plotted against the varianceof month-to-month changes in log E , which can be read off the horizontalaxis. A more nuanced picture now emerges. Figure 5 shows that, in pair-ings against the U.S., Canada is an outlier, showing both the lowest nominalexchange-rate variability and the lowest share of real exchange-rate variabil-ity explained by tradables, just under 70 percent. 17 When we examine allnon-U.S. pairings in Figure 6, however, we see that there are other instancesin which low nominal exchange rate variability is associated with relativelylow shares of tradables in real exchange rate variability, shares that can be aslow as 50 percent. Putting all the pairings together in Figure 7, U.S./Canadano longer appears as an outlier. Indeed, when nominal exchange rate volatil-ity is suppressed, factors other than changes in the relative international priceof consumer tradables appear to play a signi cant role in determining realexchange rates. They are no longer swamped by huge nominal exchange ratechanges, as in Figures 1-4. 18

Figures 5-7 nonetheless con rms the main conclusions we have alreadyreached. Even for xed exchange rate pairings such as Austria/Germany, rel-ative tradables prices still play a very big role (over 50 percent) in explainingreal exchange rate changes. Even this number suggests considerable market

segmentation at the consumer level. That nominal exchange rate changesalone seemingly can induce large, persistent changes in relative tradablesprices, without setting into motion any prompt, noticeable arbitrage mecha-nisms, is a further indication of segmentation. Finally, the fact that nominalvolatility plays so strong a role in driving relative international price changesis more evidence of stickiness in domestic nominal prices. Indeed, the databehave as if all consumer prices are sticky in domestic currency terms, eventhe prices of goods that may be imported from abroad.

17 The countries paired with the United States in Figure 5 are Austria, Canada, Den-mark, Finland, Germany, Greece, Japan, the Netherlands, Spain, Sweden, Switzerland,and the United Kingdom.

18 These types of results also occur in the bilateral comparisons carried out by Rogers andJenkins (1995), but they do not systematically compare the correlation between nominalvolatility and the importance of LOOP deviations in determining real exchange rates.

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2.4 Direct Evidence on P ricing to M arket

The preceding evidence leads to the conclusion of both sticky domestic pricesfor consumer goods and high barriers between countries consumption-goodsmarkets. Assumptions on consumer prices are key components of any macro-model, since consumer decisions are based on those prices and will in uencethe economys response to disturbances. Because the ultimate consumer isseveral steps removed from the port of entry of import goods, however, nd-ings such as Engels (1999) have only an indirect bearing on the height of barriers to international trade between rms , which accounts for most of in-ternational trade. Consumer prices, in addition to incorporating the importprices of the underlying commodities purchased, also re ect the costs of non-

tradable components such as retailing costs, internal shipping, and the like.These nontraded inputs make it di ffi cult to assess the speci c role of barriersto international trade in the underlying tradable commodities. They alsomake it harder to draw conclusions about the stickiness of import prices.

Further ambiguities come from the impossibility of ensuring that evendisaggregated CPI data from di ff erent countries represent in any sense theprices of identical goods. Not only does index composition di ff er across coun-tries with respect to subcategories of the tradable, there is also no way toensure that even very similar tradables included in two indexes originate fromthe same producer.

Recent evidence on pricing to market (PTM) in international tradehas helped to resolve these di ffi culties. The term PTM, coined by Krugman(1987), refers to third-degree price discrimination by an exporter, based onthe location of importers. 19

Using detailed disaggregated data on the di ff erent prices that individual rms set for the same good exported to di ff erent locations, the econometriciancan control for unobserved marginal production cost while ascertaining how

19 Under rst-degree price discrimination, a monopolistic producer can perfectly exploitthe heterogeneity among consumers by quoting each individual buyer a si ff erent price (orcourse, resale must be prevented). Under second-degree price discrimination, the monop-olist does not observe any signal of consumer type and can exploit heterogeneity only byinducing self-selection on the part of consumers. Under third-degree price discrimination,the monopolist bases price on an observable signal about consumer typein the presentcontext, national location. (For further discussion see Tirole 1988, p. 135.) As under rst-degree price discrimination, trade impediments must rule out arbitrage between di ff erentconsumer types. That is, pricing to market cannot take place unless there is internationalmarket segmentations.

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exchange rate changes relative to di ff erent destinations a ff ect prices charged.

Under perfectly competitive conditions and costless international trade, anexporters home currency price is determined entirely by domestic marginalcost; thus, given marginal cost, the exporter will raise price to any destinationcountry fully in proportion to an appreciation in the source countrys nominalexchange rate against the destination country. In other words, the extent of exchange-rate pass-through is unitary. When pass-through is incomplete,however, there is evidence of PTM.

The extent of PTM di ff ers across source countries and products, of course.In their excellent survey of studies on international pricing, Goldberg andKnetter (1997, p. 1244) conclude that a price response equal to one-half the exchange rate change would be near the middle of the distribution of estimated responses for shipments to the U.S. The markup adjustment fol-lowing an exchange rate change, according to them, generally occurs withina year.

2.5 On the N eed for a SynthesisPerhaps the most salient feature of the data is that nominal exchange ratechanges are associated with virtually commensurate uctuations in real ex-change rates. Moreover, relative international consumer prices of even trad-able manufactured goods seem to move virtually one-for-one with the nominalexchange rate. At the level of consumers, the pass-through from exchangerates to import prices is virtually zero in the short run. Further up thedistribution chain, where imports rst enter a country, the pass-through of exchange rate changes to prices generally is positive, but substantially belowone. Market segmentation allows exporters to change destination-speci cmarkups in response to exchange rate movements.

The accumulation of such evidence highlighted how some basic assump-tions shared by the monetary and intertemporal approaches contradict cen-tral policy-relevant facts. Both approaches fail to incorporate short run pricerigidities, and both assume complete pass-through of exchange rate changesto import prices.

Despite building in nominal rigidities, the Mundell-Fleming model, takenliterally, also assumes unitary pass-through from the exchange rate to im-port prices. That e ff ect is central to the expenditure-switching e ff ect of ex-change rates, which is the key feature giving monetary policy its e ffi cacyunder exible exchange rates, or allowing exchange rate changes to counter

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nation-speci c shocks in Mundells (1961b) optimum currency area analysis.

The empirical failures of the standard models developed before 1990 wereunsatisfactory not only from a positive point of view, but because they re-duced applicability to questions of policy. The Mundell-Fleming model, forexample, makes no distinction between retail and wholesale import prices,and it would have to be modi ed to capture both the near-zero pass-throughof the exchange rate to consumer prices of imported goods and the par-tial (but positive) pass-through of the exchange rate to the prices exporterscharge. The precise way this is done, however, has critical policy impli-cations. If one abstracts from partial exchange-rate pass-through at thewholesale level, as Engel (2000) does, then the expenditure-switching e ff ectof the exchange rate disappears entirely: exchange rate shifts do not alterthe prices consumers face, and there is no rm-to- rm trade. On the otherhand, if partial pass-through by exporters does a ff ect economic decisions, theexpenditure-switching e ff ect is present, albeit perhaps in a muted form.

As another example, its failure to incorporate price rigidities dramaticallyreduces the policy utility of the intertemporal approach (except, perhaps, forvery long-run issues). How can one accurately evaluate an economys depar-ture from external balance without some notion of its distance from internal balance, that is, a state of zero output gap and near-target in ation? Howcan one evaluate the equilibrium real exchange rate without some notion of the kind and height of the barriers separating national markets? How can one

conduct welfare analysis without an attempt to model the economys distor-tions, including those due to price rigidity? By the late 1980s and early 1990s,the clash of theory and data suggested the need for a coherent synthesis of the Keynesian and intertemporal approaches within an empirically-orientedframework.

3 T he New Open Economy M acroeconomicsThe most recent synthesis of earlier approaches combines monopolistic pro-ducers with nominal rigidities in a dynamic context with forward-looking

economic actors. As proponents of the New Keynesian approach to closed-economy macroeconomics argued in the late 1980s, monopoly is a natural as-sumption in any context with price setting, and imperfect competition helpsrationalize the idea that output is demand determined over some range, sinceprice exceeds marginal cost in the absence of unexpected shocks. Moreover,

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is a rather incidental feature; despite it, the model is isomorphic in its es-

sential implications to the non-LCP model of Obstfeld and Rogoff

(1998).The main action occurs in rm-to- rm trade that is driven by exchange rate uctuations.

3.2 A Stochastic M odel with Local-Currency P ricingto M arket

Multiperiod dynamics are not central to the e ff ects I wish to explore here, so Ispecify a model in which all economic action save the setting of nominal wagesand consumer prices takes place within a single period. Nominal wages andconsumer prices are set before the market period. The model combines PTM-LCP for nal consumption goods with marginal cost, source-country currencypricing for intermediate goods. It can, alternatively, be interpreted as a modelin which rms produce some intermediate imports at foreign subsidiaries,rather than importing them from separate entities located abroad. Ranganand Lawrence (1999) stress sourcing decisions as a major channel throughwhich exchange rate movements in uence trade ows and, hence, aggregatedemands for countries outputs.

There are two countries, Home and Foreign. Home contains a unit interval[0, 1] of workers indexed by i. Each supplies, in a monopolistic fashion, adistinctive variety of labor services. They have identical preferences

U =C 1

1

K

L ,

where > 0, > 1 and the real consumption index C is a composite of acontinuum of nal commodities indexed by j [0, 1],

C = Z 1

0C ( j )

1 d j

1

, > 1.

In the utility function P is the usual CPI function of the individual nominalcommodity prices P ( j ). Foreign is symmetric, but with prices and quantities

denoted by asterisks. Importantly, K is a stochastic shock to labor supplythat the monetary authorities may be able to respond to after sticky nominalprices are set.

Home produces a homogeneous intermediate good Y h Its nominal domestic-currency price is P h , and with free-trade in intermediates, P h = P h / E , where

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E , the nominal exchange rate, is the Home-currency price of Foreign currency.

The Home intermediate good is produced under competitive conditions outof all of the distinctive variety of domestic labor services. (Similarly, Foreignproduces the intermediate Y f , with foreign-currency price P f , etc.) Theassumption of full and immediate pass-through for intermediates is not re-alistic, but it simpli es the model and as long as there is an economicallysigni cant pass-through, of the type suggested by Figures 8-11, my mainresults will go through. The production function for either intermediate is:

Y = Z 1

0L(i)

1 di

1

, > 1.

Nominal wages W (i) [W (i) in Foreign] are set in advance to maximize

EU i . The demand for labor variety i in this setting is

L(i) = "W (i)W #

Y

(in Home or Foreign), where

W = Z 1

0W (i)1 di

1

1

.

Because intermediates markets are perfectly competitive, P h = W and P F =W .

A Home nal-goods producer (or distributor) j manufactures nal con-sumption Y ( j ) out of the Home and Foreign intermediates according to theproduction function

Y ( j ) = 2 Y h ( j )1 / 2 Y f ( j )1 / 2 (1)where Y h ( j ), for example, is input of the Home-produced intermediate intoproduction of nal consumption good j . But, as noted above, substitutionbetween production inputs can be viewed as a sourcing decision. [For For-eign, Y ( j ) = 2 Y h ( j )1 / 2 Y f ( j )1 / 2 .] The Home (Foreign) distributor distributesexclusively in Home (Foreign), so that in a sense, nal consumption goodsare nontradables and in equilibrium, C ( j ) = Y ( j ) and C ( j ) = Y ( j ). I as-sume that consumers have no way to arbitrage across international markets

ex post.The nal-goods rm must hold domestic money in order to transform

intermediates into retail consumer goods. Speci cally, a Home rm j willchoose

M ( j ) = P 1 / 2h P 1 / 2

F C ( j ),

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while a Foreign rm chooses

M ( j ) = P 1 / 2h P 1 / 2F C ( j ).

[Note that P 1 / 2

h P 1 / 2

F is the minimal Home-currency cost of producing a unitof nal consumption good, given the production function of eq. (1).] Thismoney-in-the-production-function formulation is one way of imposing ademand for money on the model; Henderson and Kim (1999) describe arelated device in the context of consumer money demand.Aggregate moneysuppliesM and M , like K and K , are random variables with realizationsthat do not become known until after wages and nal product prices are set.

The model assumes an extreme home bias in equity ownership, such thatHome (Foreign) residents own all shares in the stock of the Home (Foreign)distributor. The (ex post) budget constraint of representative Home residenti is

P C i = W (i)L(i) + Z 1

0 ( j )d j,

where ( j ) denotes nominal pro ts of rm j , and his/her rst-order conditionfor the pre-set nominal wage, W (i), is:

E (C

P (1 )L(i) +

KL (i)

W (i) )= 0or

W (i)

P =

1!E {KL (i) }

E {L(i)C } . (2)Recall that in the present setup with the CPI preset in domestic currencyterms, P is deterministic and can be passed through the expectations oper-ator. Aside from that modi cation, this rst-order condition is the same asin Obstfeld and Rogo ff (1998, 2000a).

The more novel element is the rst-order condition for the nal-goods rm, which presets consumer prices in local currency. Let T denote realgovernment transfers to Home rms. Consider the maximization problem of Home rm j , which chooses P ( j ) in advance to maximize the expected value(to its domestic owners) of pro ts

EnhP ( j )C ( j ) P 1 / 2h P 1 / 2F C ( j ) + P T + M j0 P 1 / 2h P 1 / 2F C ( j )iC

osubject toC ( j ) = "P ( j )P #

C.

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That is, the rm (in eff ect) maximizes

EP ( j )P

1

(1 + )P 1 / 2h P 1 / 2

F "P ( j )P #

C 1

with respect to P ( j ), a problem that yields the rst-order condition

P ( j ) = P = 1!E n(1 + )P 1 / 2

h P 1 / 2

F C 1 oE {C 1 }= 1!En(1 + )(W W )

1 / 2 E 1 / 2 C 1 oE {C 1 } .Of course, the Foreign CPI is preset at the level

P = 1!En(1 + )(WW )1 / 2 E 1 / 2 C 1 oE {C 1 }

I have written the preceding equation for P in terms of C rather than C because the model implies that C = C in equilibrium, PTM notwithstand-ing. To see why, notice that the Home budget constraint (in equilibrium,after eliminating the government budget constraint) gives

P C = W L +

= W L + hP W

12

(E W )

12

iC orC = E W W

12

L = E W W

12

Y h . (3)

For Foreign, one nds that

C = E W W 12

Y f .

Clearing of the markets for Home and Foreign intermediates gives

Y h = 12 E W W

12

C + 12 E W W

12

C ,

Y f =12 E W W

12

C +12 E W W

12

C .

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Substituting for C and C in either of these yields the equilibrium relative

price E W W

=P f P h

=Y hY f

,

from which it follows that

C = C = Y 12

h Y 12

f .

Let us now assume that all of the exogenous variables driving the econ-omy are lognormally distributed. It then becomes relatively straightforwardto combine the preceding rst-order conditions to obtain loglinear price andconsumption equations which parallel precisely those derived in Obstfeld andRogoff (1998, 2000a). These equations, importantly, involve the second aswell as the rst moments of the (random) endogenous variables. The log-linearized equations for CPIs (with lowercase letters denoting natural loga-rithms) are

p = log "(1 + ) 1 #+ 12Ee + 12(w + w ) + (1 )2

2 2c +

18

2e +(1 )

2 ce,

p = log "(1 + ) 1 # 12Ee + 12(w + w ) + (1 )2

2 2c +

18

2e (1 )

2 ce,

which together imply

Ee + p p = (1 )ce.

This is the equation for the ex ante CPI real exchange rate. (The intuitionturns on how production coststhe exchange rate termand hence pro tcovaries with demand and with the marginal utility of consumption; seeObstfeld and Rogo ff 2000a.)

To derive the (log) expected terms of trade, use eq. (3) to rewrite eq. (2)(in a symmetric equilibrium) as

W P

= 1! E {KY

h }E {Y h C }

= 1!EK E W W

2 C

E

E W

W

12 C 1

;

in Foreign,

W P

= 1!E K E W W

2 C

EE W W

12 C 1

.

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Let us assume that the rst and second moments of and are the same.

Loglinearize the preceding equations in the usual way, and combine themwith the equations for p and p above. The result is the very familiar pair of equations for the expected terms of trade and expected consumption equa-tions (see Obstfeld and Rogo ff 1998, 2000a):

Ee + w w = ce 12

( e + e) + ( c c) E , (4)

Ec = " + (1 )2 # 2c 28

2e +

2 ( c + c) + 4 ( e e)

(1 ), (5)

where 1

(1 ) (log"( 1) ( 1)(1 + ) # E 12

2).

We can derive ex post levels of consumption and the exchange rate fromthe monetary equilibrium conditions. The (binding) Home and Foreign CIAconstraints imply that in equilibrium

m = log +12

w +12

w +12

e + c,

m = log +12

w +12

w 12

e + c.

Form these one derivese = m m (6)

andc =

12

(m + m ) 12

(w + w ) log . (7)

These expressions can be used to analyze the variances and covariances af-fecting the economys equilibrium in terms of the models exogenous shocks.

A couple of immediate points can be made about the model. First, since p and p are predetermined, the CPI real exchange rate will be perfectlycorrelated with the nominal exchange rate e, close to what one sees in the

data. Nominal exchange rate uctuations induce commensurate changes inthe international prices of supposedly tradable consumption goods.Second, the model includes a substantial expenditure-switching e ff ect of

exchange rate changes, one that operates at the rm rather than at theconsumer level. Solving the model, one can show that:

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y = m 12

(w + w ) log ,

y = m 12

(w + w ) log .

An increase in a countrys money supply depreciates its currency and leads toa proportional rise in output and employment in this model. If Home raisesm, Foreign output is una ff ected (a knife-edge result) because the negativeexpenditure-switching e ff ect of the rise in e on y is exactly off set by theaccompanying rise in world consumption spending c. Nonetheless, domesticmonetary policy can di ff erentially aff ect domestic output through its impacton the nominal exchange rate. 24

3.3 Optimal Policy and A lternativeExchange R ate R egimesOne major advantage of stochastic models in the new open economy macroe-conomics is that they allow a complete stochastic analysis of welfare underalternative exchange rate regimes in the presence of sticky prices. That enter-prise goes well beyond what was possible before, and opens up the prospectof a rigorous evaluation of alternative systems. In the example of this sec-tion, for example, countries clearly can gain if they can gear monetary policyreaction functions toward o ff setting shocks to K and K , as in Obstfeld andRogoff (2000a). That factor increases the relative attractiveness of nationalmonetary policy autonomy, for reasons that Mundell (1961b) spelled out.

It is straightforward to illustrate optimal policies and evaluate alterna-tive monetary regimes in the present model. One simplifying feature of thismodel, which also holds in my 1998 paper with Rogo ff but not in our 2000apaper, is that, regardless of the policy rules the two countries adopt, Homeand Foreign always enjoy equal expected welfare levels:

EU = E U .

(See the appendix for a derivation.) An implication is that there are nopotential divergences of interest between the countries; any development thataids or hurts one automatically a ff ects the other identically. This implication

24 Were wages exible instead of sticky, the impact of domestic money on domesticoutput would be reduced to m/ < m.

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of the model is not realistic; however, it greatly simpli es the analysis of

policy regimes because coordination issues can be ignored.What is the preceding common level of global welfare? Making use of another result derived in the appendix, we see that

EU = (1 + ) (1 ) ( 1) ( 1)

(1 + ) (1 )E nC 1 o,

so that expected utility is proportional to

E (C 1

1 )= 11 exp"(1 )Ec + (1 )2

2 2c#.

A further simpli cation is to express the (log) productivity shocks in termsof global and idiosyncratic components,

w +

2, d

2

,

which are mutually orthogonal and satisfy 2 = 2 =

2 w +

2 d . Equa-

tion (5), nally, implies that we can fully understand the ex ante welfareimplications of policy rules by considering their e ff ects on the expression

V Ec +(1 )

2 2c =

2 2c

28

2e + w c +

2 d e

(1 ). (8)

Optimal policy rules take the form

m Em = d (w E) , m Em = d (w E) .

These rules, combined with eqs. (6) and (7) above, allow us to express theworld welfare criterion V de ned by eq. (8) in terms of the parameters , , , and . For example, the term 2c in V can be written as

14 (

)2 2 d +14 ( + )

2 2 w . By setting V/ = 0 (similarly for the other policyparameters) and solving, we nd that the optimal policy rules entail

= = 1

, = = 1 (1 )

.

These monetary rules have an intuitive interpretation. As one can verify, theyallow the global economy to attain the exible-wage and price real resource

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allocation ex post, notwithstanding nominal price rigidities. A similar inter-

pretation characterized optimal policies in the non-PTM, traded-nontradedgoods model in Obstfeld and Rogo ff (2000a).In that paper, Rogo ff and I worked through the properties of a number

of possible exchange rate regimes, showing how to carry out exact welfarecalculations and rankings. The paper showed that an optimal oat, inwhich countries commit to optimal monetary rules analogous to those justderives, dominates an optimal x, in which national money supplies areperfectly correlated but the world money supply responds optimally to theglobal shock w. Of course, the latter regime dominates a global monetaristregime in which exchange rates are xed and the world money supply is heldconstant in the face of the real shocks. All of those results extend directly tothis sections model.

An alternative conceptual experiment considers an asymmetrical one-sided peg regime. Suppose that one of the countries (Home, say) can choosethe monetary policy rule it prefers on nationalistic grounds while Foreignis required to peg its currencys exchange rate against Homes. One canshow in that case that the center country, Home, will choose = 0 and = 1 / [ (1 )] , as under an optimal x, while the passive country,Foreign, must likewise choose = 0 and = 1 / [ (1 )] in order tomaintain a xed exchange rate against Home. Global welfare thus is thesame, here, as under an optimal cooperative xed-rate regime. Why? Under

one-sided pegging by Foreign, a Home monetary policy rule that respondedin a contractionary fashion to d would force Foreign to shrink its money sup-ply when hit by favorable idiosyncratic real shocks. That would be harmfulto Foreign, leading to a contractionary expected output response there thatwould reduce Home and Foreign ex ante consumption equally. As a result, itis in Homes self-interest (given Foreigns monetary behavior) to weight do-mestic and Foreign real shocks equally in its monetary policy response rule.This is not a general result. It need not hold, for example, when countriesexpected welfare levels can di ff er as a result of a direct utility e ff ect of theexpected terms of trade, E , as in my 2000a paper with Rogo ff .

3.4 Other A pplicationsThe class of model that I have just illustrated can reconcile the old-timereligion of Mundell and Fleming with the evidence on international prices.But the range of applications goes much further. One of the most striking

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implications of the model is that uncertainty can a ff ect the rst moments

of endogenous variables such as the terms of trade and consumption. Forexample, a rise in Home monetary variability raises the prospects that Homeworkers will be called upon to supply unexpectedly high levels of labor whenconsumption is high and the desire for leisure greatest. That e ff ect tends toraise domestic relative wages and lower worldwide consumption; see eqs. (4)and (5).

This natural incorporation of uncertainty under price rigidity suggeststhat we may nally be close to understanding, at an analytical level, someof the gains monetary uni cation confers by eliminating exchange rate un-certainty. Those gains are fundamental to the a ffi rmative case for monetaryunion, as outlined so brie y in Mundells (1961b) optimum currency areapaper, yet progress in understanding them had been so slow that Krugman(1995) was led to identify progress in this area as the major challenge forinternational nance.

What forms is the new research on stochastic dynamic Keynesian modelstaking? New developments have occurred on several fronts:

We now have some rigorous general-equilibrium models allowing usto investigate the links between exchange-rate variability and interna-tional trade; see, for example, Bacchetta and van Wincoop (2000).

We have the prospect of understanding the characteristics of the risk

premia in interest rates and forward exchange rates within dynamicKeynesian settings; see Obstfeld and Rogo ff (1998) and Engel (1999).

We can begin to contemplate a full integration of classical interna-tional macroeconomic questions with issues of liquidity and nancialconstraints (see, for example, Aghion, Bacchetta, and Banerjee 2000).

We can now reformulate the analysis of international policy coordina-tion in terms of coordination on policy rules , a topic that has becomequite important as institutional reform of monetary institutions hasproceeded at the national level; see Obstfeld and Rogo ff (2001).

4 ConclusionIn this lecture I have outlined the major challenges facing international mon-etary analysis at the start of the postwar era, and some of the remarkable

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strides forward that have been made over the half century since the publi-

cation of Meades (1951) landmark work, The Balance of Payments. I endon an upbeat noteI think we can now claim to have progressed far beyondthe point where anyone can seriously argue that Its all in Meade, or inMundell and Fleming, for that matter. But I do not want to minimize, ei-ther, the work that remains to be done, both in the areas I have discussedin this lecture and in others that I have not touched upon. Though there ismuch to learn still, I believe that the promising recent developments will pro-mote continued growth in our understanding of international macroeconomicrelations.

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Appendix: Expected Utilities in the PTM-LCP ModelThe text established that the rst-order condition for nominal wage set-

ting (by worker i) is

E(C

P (1 )L(i) +

KL (i)

W (i) )= 0 , (9)that the retailers set the nominal price of nal consumption goods so that(for every retailer j )

P ( j ) = P =

1

E

n(1 + )P

1 / 2h P

1 / 2F C 1

oE {C 1

}(10)

=

1En(1 + )(WW )1 / 2 E 1 / 2 C 1 oE {C 1 } ,

and that C = C always, where C is nal consumption. For the Foreignprice P , the last equality in eq. (10) holds with the sole modi cation thatE 1 / 2 is replaced by E 1 / 2 .

Using this information, one can evaluate

EU = E (C 1

1

K

L ),from which it will follow that EU = E U . To do so, start by invoking thebudget constraint

P C = WL + = WL + hP W 12 (E W )

12 iC,

where (as before) denotes the pro ts of the domestic retailing rms (ownedentirely by domestic residents). The preceding equation implies that

W L = W 12 (E W )

12 C,

so that eq. (9) becomes (after multiplying through by the predeterminedwage and suppressing the i index)

1P

EnW 12 (E W )

12 C 1 o=

1

E {KL } .

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(Remember that P is predetermined too.)

The next step is to substitute eq. (10) for P on the left-hand side above.The result is

E {C 1 } EnE 12 C 1 o

EnE 12 C 1 o

= E nC 1 o= (1 + )

( 1) ( 1)E {KL } .

One now concludes that

EU = E (C 1

1

( 1) ( 1) (1 + )

C 1 )=

(1 + ) (1 ) ( 1) ( 1) (1 + ) (1 ) EnC

1

o= (1 + ) (1 ) ( 1) ( 1) (1 + ) (1 )

En(C )1 o

= E U ,

as claimed above in section 3.3.

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Alexander, Sidney S., E ff ects of a Devaluation on a Trade Balance, Sta ff Papers , International Monetary Fund (Washington), 2 (April 1952): 263-78.

Altonji, Joseph G., and Paul J. Devereux, The Extent and Consequences of Downward Nominal Wage Rigidity, National Bureau of Economic ResearchWorking Paper 7236 (July 1999).

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Documents

Obstfeld, Maurice. "International Macroeconomics: Beyond the Mundell-Fleming Model." International Monetary Fund Staff Papers. Special Issue, 2001