Working Paper: CEPR ID: DP7979
Authors: Wendy Carlin; David Soskice
Abstract: "Macroeconomics without the LM curve" has begun to move advanced undergraduate closed economy macroeconomics teaching models away from the IS/LM approach to simple versions of the New Keynesian models taught in graduate courses and used incentral banks. But the equally traditional and antiquated Mundell-Fleming model still dominates undergraduate open economy macroeconomics. We develop a graphical and simplified New Keynesian model of the small open economy to replace it. The modelfeatures rational expectations in both the foreign exchange market and the central bank, and is well-suited to analyze how an inflation targeting central bank responds optimally to a variety of shocks. The graphical approach highlights how exchange rate expectationsin the open economy impinge on the central bank?s decision-making. The basic model assumes the central bank targets domestic inflation and we show how a CPI inflation target modifies the analysis.
Keywords: CPI inflation targeting; domestic inflation targeting; exchange rate overshooting; Mundell-Fleming model; new Keynesian open economy model; optimal monetary policy rule
JEL Codes: E1; E3; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shock (Y60) | interest rate (E43) |
| interest rate (E43) | output (C67) |
| shock (Y60) | inflation (E31) |
| inflation (E31) | output (C67) |
| real exchange rate depreciation (F31) | net exports (F29) |
| net exports (F29) | output (C67) |
| central bank's understanding of foreign exchange expectations (F31) | effectiveness of monetary policy (E52) |