A theoretical analysis of modern assumptions and international spillovers in new open economy macroeconomics

This thesis seeks to disentangle the impact of common assumptions in contemporary two-country NOEM models on macroeconomic outcomes. We introduce completeness of markets, a Taylor-type monetary policy rule, and Calvo-style price rigidities in the seminal Obstfeld & Rogoff (1995) paper (OR henceforth). Although not unique to our model, we emphasise analytical tractability by examining how these assumptions affect macroeconomic mechanics and spillover effects. First, in Chapter 1 we introduce market completeness by enforcing perfect risk-sharing across countries. Compared to OR’s results, a home money supply shock increases Home output while reducing Foreign output more than in OR. We also find that a monetary shock generates counter-intuitive welfare effects. Next, in Chapter 2 we introduce a Taylor rule for monetary policy, where the central bank adjusts interest rates in response to inflation deviations from target. Under complete markets, world consumption moves one-to-one with the monetary policy shock, while the sign of the output spillover is ambiguous and depends on the relative strength of price elasticity and central bank responsiveness. Under incomplete markets, the output spillover remains as under complete markets. The consumption spillover, while ambiguous, is still negative for a reasonable set of parameter values. We also show that the exchange rate solution can be determined independently from consumption and output. Finally, in Chapter 3 we introduce Calvo-style pricing. This generates persistence in the output differential between Home and Foreign countries and slower adjustment to monetary shocks, departing from OR’s instantaneous adjustment. With complete markets, the spillover effect on consumption follows world consumption, so that a contractionary policy shock yields a positive spillover sign. The spillover sign on output is again ambiguous, though positive for a set of plausible parameter values.