ABSTRACT
In this chapter, and the next, we consider exchange rate models based on the so-called new open economy macroeconomics (NOEM) of Obstfeld and Rogoff. In this chapter we consider two base-line models: the two-country and small-country variants of the NOEM. As in the variants of the Lucas monetary model considered in Chapter 3, the NOEM class of models have at their heart the optimising behaviour of agents, although in the NOEM this is combined with monopolistic producers who set prices one period in advance in their own currency (i.e. there is producer pricing and complete pass-through). The monopolistic element of these models means price exceeds marginal cost and, even with short-run price stickiness, the monopolist is prepared to supply more output in response to increases in demand. Output is therefore demand determined in this class of model. One of the major advantages of this approach is that it readily facilitates the analysis of the welfare effects of macroeconomic policy. The approach stemmed from Svensson and van Wijnbergen (1989) and was further developed and fleshed out by Obsfeld and Rogoff (1995, 1996, 2000a,c). A more tractable variant of the model is presented in Corsetti and Pensetti (2001) and Lane (2001) provides a useful survey of this literature.
