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The paper develops a simple stochastic new open economy macroeconomic model based on sticky nominal wages. Explicit solution of the wage-setting problem under uncertainty allows one to analyze the effects of the monetary regime on welfare, expected output, and the expected terms of trade. Despite the potential interplay between imperfections due to sticky wages and monopoly, the optimal monetary policy rule has a closed-form solution. To motivate our model, we show that observed correlations between terms of trade and exchange rates are more consistent with our traditional assumptions about nominal rigidities than with a popular alternative based on local-currency pricing.

There has been an explosion of academic literature on the “new open economy macroeconomics” in the last several years (see Lane, 1999 for an excellent survey).1 Very recent contributions have sought to understand more deeply the positive macroeconomic effects of uncertainty as well as the normative implications for alternative international monetary regimes. As we showed in Obstfeld and Rogoff (1998), important effects of uncertainty – including effects on economic activity levels – can compound or offset the more obvious welfare effects of variability. These effects are central to accurate regime evaluation, yet they are masked by the linearization techniques commonly used to solve dynamic stochastic models. In this paper we present a simplified sticky-price model with an exact closed-form solution. The model illustrates simply and clearly both the positive effects of uncertainty and the implications for welfare.2 The possibilities for modeling nominal rigidities are inherently more numerous in a multicurrency international economy than in the single-money closed economy setting. For example, if output prices are pre-set in nominal terms, in what currencies are they denominated? In an international setting, moreover, it is natural to consider the possibility of segmentation between national markets, with prices for the same product being set in different currencies in different markets. Indeed, much interesting recent work in the new open economy macroeconomics is built on a pricing-to-market paradigm in which prices of imported goods are temporarily rigid in the importing country’s currency. In the new models, nominal exchange rate changes tend to have small or negligible short-run effects on international trade flows. This new view contrasts sharply with the traditional Keynesian approach, which assumes that prices are rigid only in exporters’ currencies, but not in importers’ currencies, so that the exchange rate plays a central role in the international transmission of monetary disturbances. Before presenting our formal model, we therefore address the empirical issue of which approach is closer to reality. We show that a framework in which imports are invoiced in the importing country’s currency implies that unexpected currency depreciations are associated with improvements rather than deteriorations of the terms of trade. Section 2 of the paper presents empirical evidence suggesting that this implication is decidedly counterfactual. Instead, the aggregate data suggest a traditional framework in which exporters largely invoice in home currency and nominal exchange rate changes have significant short-run effects on international competitiveness and trade. The formal model we present in 3, 4 and 5 falls clearly in the traditional mold. In principle, the model permits deviations from purchasing power parity to arise either from pricing-to-market or from the presence of nontraded goods, but the only nominal rigidity is that of domestic wages.3 Because of markup pricing in monopolistic output markets, inflexible wages lead, in equilibrium, to domestic-money price stickiness in the prices of tradable and nontradable products. Exchange rate fluctuations therefore cause sharp changes in both the terms of trade and the real exchange rate. We analyze wage setting in this general equilibrium context, and show how uncertainty impacts the expected level of the real exchange rate, the terms of trade, and relative output and employment levels at home and abroad. As in Obstfeld and Rogoff (1998), the need to set some prices in advance of the resolution of market uncertainties leads to ex ante markup behavior through which uncertainty affects the expected levels of key quantities and prices, possibly with large effects on welfare. Section 6 explores efficient monetary policy and shows assumptions under which one can solve exactly for efficient policy rules. This section also compares welfare under the optimal monetary regime with welfare under various forms of fixed rates and fixed money growth rules. The welfare rankings are surprisingly elegant and simple. A concluding section summarizes and suggests some directions for future research in this rapidly growing area.

In this paper we have developed a remarkably simple and tractable stochastic model following the approach of the “new open economy macroeconomics.” The model can be used to answer a variety of theoretical and policy questions, including questions about welfare under alternative monetary regimes. Thanks to the model’s log-linearity, we are able not only to derive exact closed form solutions for levels and variances of all the endogenous variables in the model, but we are also able to derive exact welfare results, despite the complication that there are two sources of market imperfection, monopoly and wage stickiness. We show that a constrained optimal global monetary policy is procyclical with respect to productivity shocks, and demonstrate how to calculate the welfare costs of keeping the exchange rate fixed in response to asymmetric shocks. We also consider the stabilization cost of instituting a regime of global monetarism in which the monetary authorities forgo offsetting global shocks. Because the welfare results are so simple and tractable, the model is potentially quite useful for analyzing issues of international macroeconomic policy coordination in a stochastic setting.40 We have also provided empirical evidence supporting a major building block of our model, the assumption that nominal exchange rate changes play a key role in the short run in shifting world demand between countries. That assumption, which also plays a central role in the traditional monetary model of Mundell, Fleming, and Dornbusch, implies that there is substantial pass-through of exchange-rate changes to the foreign-currency prices of domestic exports (and vice versa). In our model both the domestic-currency and foreign-currency prices of home goods are equally flexible in principle. But domestic wages are rigid, so that (optimal) markup pricing turns out to involve rigidity in the domestic-currency prices, but not the foreign-currency prices, of home goods. Because our model allows for pricing to market, there still can be systematic international price differences due to demand elasticities that differ at home and abroad. Our model explains some of the apparent failure of the law of one price by the fact that many “traded” goods contain a very large nontradable component by the time they reach final consumers. We also argue that a substantial component of rigidity in retail prices for imported goods may originate in the pricing policies of domestic importing firms that intermediate between foreign exporters and domestic consumers, though we do not explicitly model such interactions, leaving that interesting task to future research. We do not necessarily view our model as “better” than the plethora of interesting new open economy macroeconomic models built on the assumption that all prices, of both imports and exports, are equally rigid in domestic-currency terms. These interesting new models have been used to study a host of important issues, including, for example, the purchasing power parity puzzle, the linkage between macroeconomic volatility and international trade, and the welfare effects of international monetary transmission. Our approach, however, turns out to be more tractable for some questions, and the empirical findings we present suggest that, in any event, its underlying pricing assumptions are not worse than those of the recently popular PTM-LCP alternative. It is clear, however, that much interesting theoretical and empirical work remains to be done.