Abstract

On the Theory of Open Economies: A revised model for macroeconomic analysis

Scientific debate on the implications of flexible exchange rates is currently based almost exclusively on a model that is open to a number of weighty objections. Those objections are good reason to correct that model by way of amendment of the model’s specification of the demand function and by expanding the model by adding an additional market equation. Departing from the standard model, the revised model implies that (1) changes in the real value of securities and/or money assets held in foreign countries by residents act via changes in the real value of the money assets of economic units and exert immediate effects on the demand for money, commodities, securities and forms of investment in money assets, and that the various forms of investment in money assets must be regarded as substitutes, (2) the securities and money assets held abroad - in contrast to a situation with fixed exchange rates and perfectly free international capital movements - cannot be considered perfect substitutes because they involve varying risks, and (3) for the dispositions of economic units with respect to their assets, at least in the long run, it is not the nominal rate of interest on money investments that is relevant, but the real interest rate on such investments. The revised model results in international capital movements being viewed in a different light. Those capital movements reflect adjustments of stocks of assets to a new equilibrium with finite equilibrium stocks. The process of adjustment of asset stocks is effected not only via interest rate changes, but also via changes in the real value of the stocks of money assets. The “revised model” can also form the framework for analysis of other macroeconomic questions, too. For instance, employment conditions and wages can be taken into account by including the labour market, and the effects of changes in exogenous variables on employment and price level, wages, interest rates and exchange rates can be analysed. By adding hypotheses concerning the formation of expectations by economic entities relating to the trend of prices, wages, exchange rates, etc., the system can also be analysed with respect to its dynamic qualities, and the time profiles of the effects of stabilization policy measures can be investigated. In my view, the revised model is more efficient than the corresponding Keynesian models and permits more thorough discussion of new experience with flexible exchange rates.