INTRODUCTION

This chapter highlights some key topics in understanding the dynamic general equilibrium (DGE) behaviour of open economies. In line with the evolution of best practice in closed economy macroeconomic theory, DGE models are now the standard workhorse in the international macroeconomics literature. In addition, the incorporation of nominal rigidities and imperfect competition means that the current generation of open economy DGE models is also able to address the concerns of policy-makers regarding potential inefficiencies in adjusting to fundamental shocks. In this way, the ‘new open economy macroeconomics’ (NOEM) is a direct descendant of the traditional Mundell–Fleming–Dornbusch model (Rogoff 2001). While respecting this lineage, the microfounded nature of the new generation of models means that much more can be done in terms of providing a rigorous welfare evaluation of alternative policy regimes.

An open economy DGE model must contain a number of essential elements. Household preferences must be specified: this is more complex than in a closed economy model since the elasticity of substitution between home- and foreign-produced goods must be specified. This also applies to the specification of production functions since imported intermediate goods represent a potentially important linkage across economies. The international dimension of asset trade must also be specified, detailing whether home and foreign households share risks via state-contingent assets or just engage in bond trade or face even more restricted opportunities for international financial transactions. Of course, the form of nominal rigidities must also be determined (sluggishness in goods prices versus wages; the duration of rigidities): in an open economy, the researcher faces the problem of deciding the currency denomination of these sticky goods or factor prices. Finally, the nature of monetary and fiscal policies must be incorporated. Again, policy formation in an open economy involves extra dimensions in fixing the domestic policy response to foreign disturbances and evaluating whether there are gains to international policy coordination.

Lane (2001a) and Sarno (2001) provide broad surveys of this recent literature on ‘sticky’ DGE (NOEM) models that was initiated by the seminal ‘Redux’ model of Obstfeld and Rogoff (1995). Our strategy in this chapter is to focus on some key issues that are at the core of current research on open economy DGE modelling.