Obstfeld–Rogoff New Open-Economy Macroeconomics Model

The Obstfeld–Rogoff Redux model is a dynamic general equilibrium model of two interdependent economies in which nominal prices are set in advance by monopolistically competitive firms and households choose consumption and savings to maximize lifetime utility. Maurice Obstfeld and Kenneth Rogoff introduced it in the 1995 article "Exchange Rate Dynamics Redux" in the Journal of Political Economy. The title refers to Rudiger Dornbusch's 1976 paper on exchange rate overshooting, and the model reconstructs that analysis on microeconomic foundations. It launched the "new open-economy macroeconomics", a research program that merges the intertemporal approach to the current account with the nominal rigidities of Keynesian models, and it enables direct welfare analysis of monetary policy in an interdependent world economy.

The earlier workhorse of open-economy macroeconomics was the Mundell–Fleming model, which combined sticky prices and capital mobility to analyze policy under fixed and floating exchange rates. It was simple and useful, but its behavioral equations, such as ad hoc consumption and money demand functions, were not derived from optimization, and it could not provide welfare statements. The Dornbusch overshooting model added forward-looking exchange rates and rational expectations, yet it still relied on an ad hoc output demand equation and treated the current account as irrelevant.

Obstfeld and Rogoff drew on two other traditions. One was the intertemporal approach to the current account, in which countries borrow and lend to smooth consumption, with welfare grounded in preferences. The other was the monopolistic competition framework, in which firms have market power and the equilibrium output is below the efficient level. The Lucas critique provided the methodological argument: policy analysis should be conducted with models whose parameters are tied to preferences and technology.

The world consists of two countries, Home and Foreign, with populations of fixed size. Each household supplies labor, consumes a basket of differentiated goods produced by monopolistically competitive firms in both countries, and holds real money balances and an internationally traded bond. Utility depends positively on consumption and real balances and negatively on labor effort.

Key assumptions include the following.

• Monopolistic competition. Each household is the sole producer of a differentiated good and sets its price. Because consumers have a constant elasticity of substitution θ across goods, the markup is θ/(θ − 1), and output is below the competitive level in equilibrium.
• Price rigidity. Nominal prices are set one period in advance in the home currency of the producer, and they cannot adjust to monetary shocks within the period. In the long run, after one period, prices are flexible.
• Law of one price and purchasing power parity. Prices are set in the producer's currency, and prices of identical goods are equal across countries when expressed in a common currency, so purchasing power parity holds at all times.
• Asset markets. Households trade a single risk-free real bond, which allows lending and borrowing between countries and gives the current account an economic role.

The short run is the period in which prices are fixed, and the long run is the steady state in which prices have adjusted and the net foreign asset position is constant.

Monetary shocks and the exchange rate. An unexpected permanent rise in the Home money supply depreciates the Home currency. With sticky prices the depreciation lowers the relative price of Home goods and expands Home output in the short run. Because the exchange rate adjusts and, under purchasing power parity, the import price rises, Home consumption rises. The monetary expansion has a short-run effect on output that is consistent with Keynesian intuition. Importantly, the model shows that the Home currency depreciates by about the amount of the long-run money supply increase, so that there is no overshooting in the baseline model, unlike in the Dornbusch analysis: the adjustment is complete immediately in the nominal exchange rate, because with sticky prices set in the producer currency and a permanent shock, the long-run change in the exchange rate matches the change in relative money supplies.

Current-account dynamics. Higher Home output and income in the short run exceed the permanent rise in consumption, because households smooth consumption, so Home runs a current-account surplus during the period of rigidity and accumulates foreign assets. In the long run, the Home country holds higher net foreign assets and therefore enjoys a higher level of wealth and consumption, while Foreign is a net debtor with lower consumption. This wealth effect is a novel channel that earlier models without the current account could not capture. It also shows that a monetary expansion has a "beggar-thy-neighbor" component in the long run, offset by a short-run increase in Foreign consumption.

Welfare effects. Because the model has explicit utility functions, the welfare of each country can be computed. The monetary expansion raises Home output toward its efficient level, removing part of the monopolistic distortion, which is a welfare gain. Foreign welfare also rises in the baseline case, since the increase in Home output reduces the prices of Home goods that Foreign imports, and the effect on the terms of trade works in Foreign's favor. The overall welfare gain is split between the two countries, and the model finds that monetary expansion raises welfare in both economies, which supports the case for interpreting the world as a system with spillovers rather than a single country problem. These conclusions depend on the output gap created by market power, and they would change in a model with different distortions.

Subsequent work relaxed the original assumptions. Giancarlo Corsetti and Paolo Pesenti, in a 2001 article in the Quarterly Journal of Economics, studied a variant with a Cobb–Douglas aggregator between Home and Foreign goods and a unit elasticity of substitution, which makes the welfare effect of a monetary expansion depend on the terms of trade. In their model the expansion depreciates the terms of trade, so the gain in Home output comes partly at the expense of Foreign, and the expansion can be a beggar-thy-neighbor policy since the improvement in Home welfare is offset by a deterioration abroad. Their analysis showed that the sign of the international spillover depends on the elasticity of substitution, and it brought out the role of the terms-of-trade externality that the Redux model had downplayed.

Other extensions introduced local-currency pricing, in which firms set prices in the buyer's currency. This produces deviations from the law of one price and a weaker pass-through of exchange rates to import prices, with the result that the exchange rate has less expenditure-switching power. Further extensions allowed for non-traded goods, incomplete asset markets, staggered price setting following the Calvo staggered pricing model, habits in consumption, and optimal monetary policy analysis, in which the welfare function is approximated to a second order and policy rules are compared.

Compared with the Mundell–Fleming–Dornbusch tradition, the new framework replaces ad hoc behavior with optimization, ties the current account to intertemporal choice, and gives a welfare criterion. The cost is analytical complexity and heavier dependence on specification choices, such as the pricing currency and the elasticity of substitution.

Critics point to the abrupt one-period rigidity of the original model, which implies that all dynamics are over after a single period, and to the lack of exchange-rate overshooting and persistent real exchange-rate movements that are visible in data. The assumption of purchasing power parity conflicts with evidence of large and persistent deviations. Empirically, the pass-through of exchange rates to import prices is incomplete and varies across countries and sectors, favoring local-currency pricing or distribution costs. The welfare conclusions rest on a particular distortion, namely the monopolistic markup, and are sensitive to the elasticity of substitution.

The approach nonetheless reshaped the field. Modern open-economy dynamic stochastic general equilibrium models used at central banks and international institutions descend from it, and its emphasis on the joint determination of the exchange rate, the current account, and welfare remains a basis for work on global monetary policy coordination and the international transmission of shocks.

1. Obstfeld, M., & Rogoff, K. (1995). Exchange rate dynamics redux. Journal of Political Economy, 103(3), 624–660. https://doi.org/10.1086/261997
2. Corsetti, G., & Pesenti, P. (2001). Welfare and macroeconomic interdependence. Quarterly Journal of Economics, 116(2), 421–445. https://doi.org/10.1162/00335530151144069
3. Dornbusch, R. (1976). Expectations and exchange rate dynamics. Journal of Political Economy, 84(6), 1161–1176. https://doi.org/10.1086/260506
4. Mundell, R. A. (1963). Capital mobility and stabilization policy under fixed and flexible exchange rates. Canadian Journal of Economics and Political Science, 29(4), 475–485. https://doi.org/10.2307/139336