Chapter 9 : Money and the Open Economy ( Monetary Theory and Policy , 3 rd ed . )

The analysis in earlier chapters was conducted within the context of a closed economy. Many useful insights into monetary phenomena can be obtained while still abstracting from the linkages that tie di¤erent economies together, but clearly many issues do require an open-economy framework if they are to be adequately addressed. New channels through which monetary factors can in‡uence the economy arise in open economies. Exchange-rate movements, for example, play an important role in the transmission process that links monetary disturbances to output and in‡ation movements. Open economies face the possibility of economic disturbances that originate in other countries, and this raises questions of monetary policy design that are absent in a closed-economy environment: Should policy respond to exchange-rate movements? Should monetary policy be used to stabilize exchange rates? Should national monetary policies be coordinated? In this chapter, we begin in section 2 by studying a two-country model based on Obstfeld and Rogo¤ (1995, 1996). The two-country model has the advantage of capturing some of the important linkages between economies while still maintaining a degree of simplicity and tractability. Because an open economy is linked to other economies, policy actions in one economy have the potential to a¤ect other economies. Spillovers can occur. And policy actions in one country will depend on the response of monetary policy in the other. Often, because of these spillovers, countries attempt to coordinate their policy actions. The role of policy coordination is examined in section 3. Section 4 considers the case of a small open economy. In the open-economy literature, a small open economy denotes an economy that is too small to a¤ect world prices, interest rates, or economic activity. Since many countries really are small relative to the world economy, the small-open-economy model provides a framework that is relevant for studying many policy issues.