Open Economy Macroeconomics

Citation

Uribe, M., & Schmitt-Grohé, S. (2017). Open Economy Macroeconomics. Princeton University Press.

Chapter Summary

The book has thirteen chapters in a little over 600 pages. It starts from empirical facts, builds a series of dynamic general equilibrium models of the open economy of increasing complexity, and ends with financial frictions and sovereign default. According to the publisher, chapters include exercises and replication code, and the authors provide data sets and programs on the book's website.

Chapter 1: Business-Cycle Facts Around the World

Documents the empirical regularities that open economy models are meant to explain. Using annual World Bank data for about 120 countries (and then quarterly data), the chapter measures business cycles, compares poor, emerging and rich countries, looks at the effect of country size, and explains Hodrick-Prescott filtering and the treatment of growth rates. The chapter closes with a comparison of the duration and amplitude of business cycles in emerging and developed countries and with data-based exercises.

Chapter 2: An Open Endowment Economy

The simplest model in the book: a small economy with an endowment of goods that borrows and lends in international markets. The chapter works through stationary income shocks (including AR(2) processes) and nonstationary shocks, and ends with tests of the intertemporal approach to the current account.

Chapter 3: An Open Economy with Capital

Adds capital to the model. The chapter characterises the steady state and the adjustment to permanent and temporary productivity shocks, and introduces capital adjustment costs.

Chapter 4: The Open Economy Real-Business-Cycle Model

The main workhorse model. The model is set out, decentralized into households and firms, then calibrated and approximated, and its performance is assessed. The chapter compares a complete-asset-markets version with several alternative ways of inducing stationarity (internal and external debt-elastic interest rates, portfolio adjustment costs, external and internal discount factors, no stationarity-inducing feature), a perpetual-youth model, and a global solution method. An appendix covers perturbation methods and Matlab code.

Chapter 5: Business Cycles in Emerging Countries: Productivity Shocks versus Financial Frictions

Asks whether the open economy RBC model can generate the excess consumption volatility seen in emerging countries. It adds stationary and nonstationary technology shocks, lets them compete with working-capital constraints and interest-rate shocks, and estimates the model by Bayesian methods on a century of data. The last sections examine the role of financial frictions and of imperfect information and noise shocks.

Chapter 6: Interest-Rate Shocks

Begins with an empirical model, impulse response functions and variance decompositions, then introduces an open economy subject to interest-rate shocks and compares theoretical with estimated responses. It ends with global risk factors and emerging-economy business cycles.

Chapter 7: Importable Goods, Exportable Goods, and the Terms of Trade

Studies how terms-of-trade shocks matter, first with a simple empirical model and evidence on the trade balance, then with a model in which importables and exportables are distinguished (the MX model). It parameterizes the model and concludes that terms-of-trade shocks are less important in the data than in theory.

Chapter 8: Nontradable Goods and the Real Exchange Rate

Adds nontradable goods, defining the real exchange rate and setting out the TNT and MXN models. It compares their responses to terms-of-trade shocks with empirical evidence and discusses the terms-of-trade disconnect.

Chapter 9: Nominal Rigidity, Exchange Rates, and Unemployment

Introduces downward nominal wage rigidity in an open economy, The chapter analyses currency pegs under this friction, optimal exchange-rate policy, empirical evidence on wage rigidity and devaluations, the welfare costs of pegs, and the Mussa puzzle, and ends with product price rigidity and the Calvo model of staggered price setting.

Chapter 10: Exchange-Rate Policy and Capital Controls

Looks at fiscal policy under fixed exchange rates, then at capital controls: their optimality, their prudential role during boom-bust episodes, overborrowing, and whether observed controls are prudential.

Chapter 11: Policy Credibility and Balance-of-Payments Crises

A model of tax reform with and without credibility, which leads to the connection between lack of credibility, exchange-rate policy and balance-of-payments crises.

Chapter 12: Financial Frictions and Aggregate Instability

Studies stock and flow collateral constraints, self-fulfilling financial crises, debt dynamics in a stochastic economy, financial amplification, optimal capital control policy and overborrowing, and optimal consumption taxes.

Chapter 13: Sovereign Default

Starts from empirical regularities of default (frequency, haircuts, spreads) and the evidence on its costs. It then develops theories of default incentives with state-contingent and non-state-contingent contracts, the Eaton-Gersovitz model, and a quantitative analysis of that model.

Key Concepts

Chapters 1–4: Facts and Basic Models

• Business-cycle facts: volatility, comovement and persistence of output, consumption, investment and the external accounts across countries.
• Intertemporal approach to the current account: the current account as the outcome of saving and investment decisions over time.
• Stationarity-inducing features: devices that make small open economy models have a well-defined long-run level of debt.

Chapters 5–8: Shocks and Relative Prices

• Trend shocks and financial frictions: competing explanations of emerging-country business cycles.
• Interest-rate shocks: movements in the cost of external funds as a source of fluctuations.
• Terms of trade and the real exchange rate: the relative prices through which external shocks reach the economy.

Chapters 9–13: Policy and Crises

• Downward nominal wage rigidity: a friction that makes fixed exchange rates costly in terms of unemployment.
• Prudential capital controls: taxes on borrowing that correct overborrowing.
• Collateral constraints and sudden stops: borrowing limits tied to asset values or income that make crises self-reinforcing.
• Sovereign default: the borrower's decision to repay or not, with the Eaton-Gersovitz model as the benchmark.

Critical Analysis

Strengths

• Facts, models and estimation together. Each topic is introduced with empirical evidence and then modelled, and a number of chapters estimate or evaluate models against data, which the publisher singles out as combining theoretical models and data.
• A cumulative sequence. The authors begin with a canonical model and add complexity chapter by chapter, so the endowment economy of Chapter 2 grows into the models of financial frictions in Chapters 12–13.
• Computational support. The contents of Chapter 4 include Matlab code for linear perturbation methods and a global solution method, and the publisher describes exercises and replication codes.
• Focus on emerging economies and policy. Chapters 5 to 13 treat emerging-economy business cycles, exchange-rate regimes, capital controls and sovereign debt, topics the book handles in more depth than a general macroeconomics text.

Limitations

• Heavy technical demands. The tools used include dynamic optimisation, perturbation methods, the Kalman filter, Bayesian estimation and global solution methods, so the book is difficult without strong graduate preparation.
• One modelling approach. The book is organised around dynamic general equilibrium models of the open economy, as its description says, so it is not a survey of other approaches to international macroeconomics.
• Date. The data and episodes are those available up to the 2017 publication date.

Where It Fits in the Course

This is the graduate-level book on the list for open economy macroeconomics. Salvatore and Hepp's International Economics and Krugman, Obstfeld and Melitz's International Economics: Theory and Policy are undergraduate texts that cover trade and international finance in words and diagrams, and are the right preparation for the policy questions. Feenstra and Taylor's Essentials of International Economics is a one-semester version covering trade and international macroeconomics.

Feenstra's Advanced International Trade is the graduate companion on the trade side, while Uribe and Schmitt-Grohé cover the macroeconomic side. Rodrik's The Globalization Paradox is a readable account of the economics and politics of globalisation and is a useful complement to Chapters 9 and 10 on exchange-rate regimes and capital controls, with a broader view than the formal models.

How to Use This Book

The book is for first- and second-year doctoral students and researchers who have studied intermediate macroeconomics and international economics, with calculus and some dynamic optimisation.

A practical plan:

• Core: Chapters 1 to 4. Read Chapter 1 for the facts, Chapters 2 and 3 for the building blocks, and Chapter 4 for the benchmark model and its computational methods.
• Next: Chapters 5 to 8 on shocks and relative prices, then Chapter 9 and Chapter 10 on nominal rigidity, exchange-rate policy and capital controls.
• Advanced topics: Chapters 11 to 13 can be read in any order after the core, according to interest in credibility, financial crises or sovereign debt.

Work the exercises, which use real data, and run the authors' code with the data on the book's website.