Michael D. Goldberg
Winter, 1994
Department of Economics

1.0 Course Overview

The focus of open-economy macroeconomics is broad. It can be described on three levels. On one level, the field attempts to explain the workings of national economies (at the macro level) which are interconnected in a system of world trade in goods, services and assets. Some of the important questions on this level are the following: 1) How are national economies interconnected and how do these interconnections impact on macroeconomic behavior?; 2) Will an expansion of income in one country lead to an expansion of income in the rest of the world?; 3) Will a domestic currency depreciation necessarily be expansionary (contractionary) for the domestic (foreign) country?; 4) How should a small open country engineer their economic policies in the face of a volatile world economy and what are the difficulties involved?; 5) Is it sometimes optimal for such countries to run current account deficits and, therefore, borrow from the rest of the world and, if so, then when?; and 6) How do problems of debt and capital flight factor into the analysis? The modern debate on many of these questions stems back to Keynes; and, despite this 50 years of work, economists are still trying to uncover many of the answers. Of course, these answers depend on the way the international financial system is organized, i.e., do we have a fixed exchange rate system (and of which type), a flexible exchange rate system or something in between these two extremes.

This leads us to a second level of focus. Open-economy macroeconomics also concerns itself with how various international monetary systems work. The big question here (and perhaps the most important question in all of open-economy macro) concerns how best to organize the international financial system. Should a country adopt some a type of a fixed exchange rate system, a flexible exchange rate system or something in between? Should these individual choices at the national level be coordinated within one overriding world international monetary order (as was mostly the case for the 150 years prior to 1973) or should they be made individually, leading to a patchwork of different subsystems (which is what characterises the current international monetary situation)? Naturally, this leads into the study of how the various exchange rate regimes operate. What are their advantages and drawbacks in theory? What have been their advantages and drawbacks in practice?

This, then, leads to a third level on which to describe the study of open-economy macroeconomics, in that in analyzing various exchange rate regimes, the field is obliged to study the workings and institutions of the international financial markets. There are three distinct (but interrelated) international-financial markets: 1) The foreign exchange market; 2) The eurocurrency markets; and 3) The international bond markets. How are these markets organized and what are the institutions that make up them up. Do these markets work efficiently? Are market players rational? Are the markets too volatile and on what basis can this determination be made? Is speculation destabilizing or stabilising, or does some combination of the two describe reality the best?

These three levels of focus will constitute the subject matter for the semester. It is important to emphasize that these three levels are interrelated and that a firm understanding of any one requires a firm understanding of the other two. Traditional open-economy macroeconomic courses tend to focus primarily on levels one and two, with the study of international financial markets (level three) often receiving cursory treatment. Similarly, traditional courses in international finance tend to focus primarily on levels two and three, without proper treatment of the economics of interdependent macro economies (level one). I think both of these traditional approaches are deficient and this course is an attempt to remedy these deficiencies.

2.0 Course Objectives

The first objective is to stimulate interest in the study of open-economy macroeconomics. My hope is that this course will serve as a springboard in pointing the way for further study and research. The second objective is to encourage you to think seriously about two topics in particular: 1) What kind of exchange rate regime should a small open country choose?; and 2) What causes exchange rates to fluctuate the way they do in a flexible rate system? Much of the subject matter of this course is structured around these two questions.

3.0 Reading Materials (books)

The following two books will serve as the main texts for the semester:

Gandolfo, G. ( 1987), International Economics II: International Monetary Theory and Open-Economy Macroeconomics, (Berlin: Springer-Verlag). (IE)

Grabbe, J.O. (1991), International Financial Markets, (New York: Elsevier). (IFM)

3.0 Grading

There will be one mid-term exam (worth 45 percent of your grade) and one final exam, which will not be cumulative (also worth 45 percent of your grade). There will also be a paper assignment (see below) worth 10 percent of your grade.

4.0 Paper Assignment

There will be one term-paper due on Wednesday, March 30,1994. The paper must be typed, with double spacing and type that has a point size of between 11 and 12. The paper must at least at least 5 pages, but no more than 10 pages. The main subject of the paper will be on the behavior of the $/DM exchange rate during the period from January 1,1994 to March 20,1994. The paper should provide the author's view as to why the $/DM rate behaved the way it did during this period. All papers should include a graph of this behavior using daily data. The paper will also include forecasts of the $/DM exchange rate (along with a brief explanation on how these forecasts were arrived at) for the following two future dates: 1) June 31,1994; and 2) June 31, 1995. Students will find that a daily reading of the economic and financial events in either the Wall Street Journal or Financial Times will prove invaluable in fulfilling the paper assignment.

5.0 Course Outline

5.1 Introduction (1/2 week)

A general discussion on the course, open-economy macroeconomics and the issues.

5.2 Balance of Payments and National Income Accounting (1/2 week)

IE, ch. 11

Kindleberger, C.P. (1969), "Measuring Equilibrium in the Balance of Payments," Journal of Political Economy, 77, Vol. 6, pp. 873-891.

5.3 An Introduction to the Foreign Exchange Market (1 week)

IFM, chs. 3-4
IE, ch. 10

Goodhart, C. (1988), "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, Vol. 55, November, pp. 437-460

5.4 Some Theory for Open Macro Economies: The Traditional Flow Approach

(1 week)

IE, chs. 12-13

5.5 A Closer Look at the Fixed Exchange Rate Framework

5.6a The Monetary Approach to the Balance of Payments (1/2 week)

IE, ch. 15.1-15.3

Frenkel, J.A. and H.G. Johnson (1977), "The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins," in J.A. Frenkel and H.G. Johnson (eds.) The Monetary Approach to the Balance of Payments, (Toronto: University of Toronto Press), pp. 21-45.

Mundell, R.A. (1968), International Economics, (New York: MacMillan), chapter 8, reprinted in J.A. Frenkel and H.G. Johnson (eds.) The Monetary Approach to the Balance of Payments, (Toronto: University of Toronto Press), pp. 21-45.

5.6b The Keynesian Approach to the Balance of Payments: Adding in International Capital Flows and the Assignment Problem (1/2 week)

IE, ch. 15.4-15.5

Mundell, R.A. (1962), "The Appropriate Use of Monetary and Fiscal Policy under Fixed Exchange Rates," IMF Staff Papers, 9, March, pp. 70-77

Mundell, R.A. (1963), "Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates," Canadian Journal of Economics and Political Science, November, pp. 475-485.

5.7 A Look at the Historical Record: The Bretton Woods System of "Adjustable" Fixed Rates (1/2 week)

IFM, ch. 1

IE, ch. 19.1

McKinnon, R.I. (1992), "The Rules of the Game: International Money in Historical Perspective," paper prepared for the workshop on "Issues in International Economics," International School of Economic Research, University of Siena, Italy, July 2-9, 1992, sections 2 and 3, pp. 137-163.

5.8 The Theory of Flexible Exchange Rates

5.8a The Monetary Approach to Exchange Rate Determination (1/2 week)

WTP, ch. 23
IE, ch. 18.8.2-

Bilson, J. F. O. (1978), "Recent Developments in Monetary Models of Exchange Rate Determination," IMF Staff Papers, June, pp. 201-223.

Dornbusch, R. (1976), "Expectations and Exchange Rate Dynamics," Journal of Political Economy, December, pp. 1161-1174.

Frenkel, J. A (1976), "A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence," Scandinavian Journal of Economics, 78, pp. 200-224.

Goldberg, M.D. (1993b), "Long-Run Non-Neutrality in a Standard Sticky-Price Monetary Model of the Exchange Rate," C.V. Starr Center for Applied Economics Working Paper, August.

5.9 Examining the Modern Period of Floating Rates (1/2 week)

Dornbusch, R. and J.A. Frankel (1987), "The Flexible Exchange Rate System: Experience and Alternatives," paper prepared for the conference on "Survival and Growth in a Polycentric World Economy," Basle, Switzerland, October 14-17, 1987.

Frankel J. A. (1984), "Tests of Monetary and Portfolio Balance Models of Exchange Rate Determination," in J. Bilson and R. Marston (eds.), Exchange Rate Theory and Practice, Chicago: University Chicago Press.

Frankel J. A. (1983), "Monetary and Portfolio Balance Models of Exchange Rate Determination," in J. Bhandari and B. Putnam (eds.), Economic Interdependence and Flexible Exchange Rates, Cambridge: MIT press.

Goldberg, M. D. and R. Frydman (1993), "Empirical Exchange Rate Models and Shifts in the Co-lntegrating Vector," C.V. Starr Center for Applied Economics Working Paper, August.

Meese, R. and K. Rogoff (1983), "Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?," Journal of International Economics, February, pp. 3-24.

Schulmeister, S. (1987), "An Essay On Exchange Rate Dynamics," International Institute of Management Working Paper, Berlin, June.

5.10 Developing Country Issues

5.10a The Choice of Exchange Rate Regime (1/2 week)

Dornbusch, R. and L. T. Kuenzler (1993), "Exchange Rate Policy: Options and Issues," in R. Dornbusch (ed.), Policymaking in the Open Economy, Oxford: Oxford University Press.

Dornbusch, R. (1986), "Special Exchange Rates for Capital Account Transactions," World Bank Economic Review, Vol. 1, pp. 3-33.

Wickharn, P. (1985), "The Choice of Exchange Rate Regime in Developing Countries: A Survey of the Literature," IMF Staff Papers, Vol 33, June, pp. 248-288.

Williamson, J. (1982), "A Survey of the Literature on the Optimal Crawling Peg," Journal of Development Economics, Vol. 11, August, pp. 39-61.

5.10b A Look at the Impact of Bad Macroeconomic Policies in a Small Open Economy: The Case of Nigeria, 1972-1988 (1/2 week)

Gavin, M. (1993), "Adjusting to a Terms of Trade Shock: Nigeria} 1972-1988," in R. Dornbusch (ed.), Policymaking in the Open Economy, Oxford: Oxford University Press.

5.10c The Debt Problems of LDCs (1/2 week)

Dornbusch, R. (1987), Dollars, Debts, and Deficits, Cambridge, Massachusetts: The MIT Press, part II.

Calvo, G., R. Findlay, Pentti Kourl and J. de Macedo (eds.), 1989, Debt, Stabilization and Development, Oxford: Basil Blackwell, Parts I and IV.

CRC-Curriculum Resource Center
CEU Budapest, Hungary
Modified: May, 1996


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