Toward a New Paradigm in Open Economy Modeling: Where Do We Stand?

In the last few decades, there have been a number of important developments, both theoretical and empirical, in open economy macroeconomics and exchange rate economics (see, for example, Sarno and Taylor, 2001a, b). Also, the increasing availability of high-quality macroeconomic and financial data has stimulated a large amount of empirical work. While our understanding of exchange rates has improved as a result, many challenges and questions remain. This paper selectively surveys the recent literature on “new” open economy macroeconomics. This literature, stimulated by the work of Obstfeld and Rogoff (hereafter OR) (1995), reflects the attempt by researchers to formalize exchange rate determination in the context of dynamic general equilibrium models with explicit microfoundations, nominal rigidities, and imperfect competition.1 The main objective of this research program is to develop a new workhorse model for open economy macroeconomic analysis. Relative to the still ubiquitous Mundell-Fleming-Dornbusch (MFD) model (Mundell, 1962, 1963; Fleming, 1962; Dornbusch, 1976), new open economy models offer a higher standard of analytical rigor coming from fully specified microfoundations; they offer the ability to perform welfare analysis and rigorously discuss policy evaluation in the context of a framework that allows for market imperfections and nominal rigidities. On the other hand, the main virtue of the MFD model is its simpler analytical structure, which makes it easy to discuss in policy circles. Because the predictions of new open economy models are sensitive to the particular specification of the microfoundations, policy evaluation and welfare analysis depend on the specification of preferences and nominal rigidities. In turn, this generates a need for the profession to agree on the “correct” or at least “preferable” specification of the microfoundations. The present paper reviews the key contributions in new open economy macroeconomics in the last five to six years, also assessing how the intellectual debate stimulated by OR has led to models that reflect reality more satisfactorily over time. The paper also discusses some of the most controversial issues that currently still prevent any of the models in this area to emerge as a new paradigm for open economy modeling and describes the directions taken by the latest literature. The remainder of the paper is set out as follows. The first section provides a review of the seminal paper in this literature, proposing the socalled redux model, while the second section covers a number of variants and generalizations of the redux model that permit allowance for alternative nominal rigidities, pricing to market, alternative preference specifications, and alternative financial markets structures. I then discuss some stochastic extensions of these models, focusing on their implications for the relationship between uncertainty and exchange rates in the third section. Some new directions taken by the latest literature on stochastic open economy modeling are described in the fourth section. A final section presents some concluding remarks.