Author(s): Sousa, Teresa
Date: 2010
Persistent ID: http://hdl.handle.net/10362/145933
Origin: Repositório Institucional da UNL
Subject(s): Domínio/Área Científica: Ciências Sociais: Economia e Gestão; Domínio/Área Científica: Ciências Sociais: Economia e Gestão
David Ricardo's notion of comparative advantage foresees that, "under a system of perfectly free commerce, (...) the pursuit of individual advantage is admirably connected with the universal good of the whole". In other words, free trade between two nations should raise the real incomes of both. Among many other prominent economists, Milton Friedman also advocates free trade for the world economy "(...) our basic economic objective: the achievement and. maintenance of a free and prosperous world community engaging in unrestricted multilateral trade "2. Free trade in open economies has been a pursued objective for long in developed economies and a driving force of economic growth. The relation between openness and growth and the international transmission mechanism of shocks in interdependent economies has been the object of intense policy debates and academic research in international economics for the last 50 years. Discussions are focused in exchange rate regimes and the desirability of flexible or fixed exchange rates, as this is the key variable that expresses interdependence. The Mundell -Fleming model, developed in the mid XX century to study the relationship between the nominal exchange rate and output, is probably the most early 1990s a micro -founded optimizing framework dominates academic research in international economics referred to as New Open Economy Macroeconomics (henceforth NOEM). The new framework consists on general -equilibrium models extended for open economies with monopolistic competition and sticky prices, and provide welfare foundations and new insights to the intuitive premises of the Mundell -Fleming model. NOEM models answer important questions within rigorous choice -theoretic frameworks applied to the design of monetary policy rules in a strategic international setting. The central issues addressed within the NOEM literature are the ones related to international macroeconomic interdependence among countries, such as the role of the exchange rate in the international transmission mechanism and the relevance of the exchange rate regime to the adjustment of international relative prices. To the extend that flexible exchange rates are assumed throughout the models the role of the exchange rate is essentially one of an adjustment variable, as Friedman argues. Yet, making a distinction between two forms of price stickiness - producer and local currency pricing - calls into question normative issues related to exchange rate regimes. Among different specifications developed in the NOEM literature the CP-OR model3 deserves special relevance since it represents a general and tractable framework that integrates in a balanced way positive and normative issues, thus serving both academics and policymakers. It is stylized theoretical model with a closed form solution that allows the derivation of important and clear results from optimization, not undermining the conventional wisdom on open economics. Overall, and along with Friedman's notable argument, this benchmark model makes a case for flexible exchange rates arguing that flexible exchange rates are crucially needed to substitute the role of prices, usually sticky. Indeed Friedman's premises and conclusions stated 50 years ago describe overall economic interdependence in the CP -OR model and the transmission mechanism of shocks. In both cases there is no scope for monetary policy cooperation between interdependent countries since a regime of flexible exchange rates is sufficient to face optimally the consequences of economic interdependence. In light of these considerations, the objective of the following three chapters is to further investigate the international transmission mechanism under specific economic contexts of asymmetries between the Home and the Foreign country, of increased interdependence due to oil dependency and of uncertainty due to velocity of money shocks. The following essays intend to shed new light on the extend that international interdependence affects welfare and whether open economies are more or less prone to welfare variations. As is well understood, there is a trade-off between the simplicity and clarity of results and the analytical complexity of models. To provide an assessment of potential gains or losses arising under specific circumstances we perform welfare analysis and derive the arguments from two different settings and under different degrees of exchange rate pass -through on import prices: the stylized micro-founded model with closed form solutions, one period sticky prices and producer currency pricing, and a richer and more complex model solved numerically with staggered price setting and local currency pricing.
