A More Advanced Open Economy Model

The open economy model deployed in Chapter 6 was very much simplified, with fixed exchange rates and no private transactions in foreign assets, while central banks held all their foreign exchange reserves in the form of gold. In this chapter we add a number of realistic features.1 Private agents trade foreign assets. Official account imbalances are settled normally by transactions in dollar-denominated assets, with gold only playing a small role. International trade depends both on national output and relative prices, implying a distinction between nominal and real values.2 A minimum of five prices are considered: export prices, import prices, the price of sales, a domestic sales price and a GDP deflator. Fixed and flexible exchange rate regimes will both be explored. But many simplifying assumptions remain. There are only two countries, there is no domestic or foreign investment in fixed or working capital,3 firms do not hold financial assets, there is no endogenous wage inflation, there are no commercial banks or credit money, and the treatment of expectations is rudimentary. Yet we already need nearly one hundred equations to close the model and for inclusion of further realistic features we would require several more.