Open Economy Keynesian Macroeconomics without the Lm Curve

INTRODUCTION Recent developments in field of Macroeconomics have not been fully incorporated into available textbooks. Certainly, canonical New Keynesian model (see, e.g., Gali, 2008), currently representing prevailing orthodoxy in academic circles, includes, together with an IS function, a monetary policy and an aggregate supply function based on Phillips curve. However, use with didactic purposes of a model of this kind when teaching intermediate Macroeconomics is not common. In a paper published some years ago, David Romer proposed to replace the LM curve, along with its assumption that central bank targets money supply, with an assumption that central bank follows a real interest rate rule (Romer, 2000, p. 150). Assuming real interest rate is an increasing function of inflation rate, he obtained an MP (for monetary policy) function, horizontal in real interest rate-output space that, when coupled with a traditional IS function, led to a decreasing aggregate demand (AD) function in inflation rate (instead of price level)-output space. The model was completed with assumption that inflation rises when output is above its natural rate and falls when output is below its natural rate, which gave a horizontal inflation adjustment (IA) line in inflation-output space. Put together, IA-AD functions provided an alternative to AS-AD model, in terms of inflation rate instead of price level. Finally, some extensions were also discussed; in particular, analysis of open economy was referred to a companion paper available online at author's web page, where he presents a model with a monetary for both closed and open economy, but considering only aggregate demand side for latter. The first version of that paper, designed to accompany Mankiw's (2012) textbook (first edition published in 1992), dates from August 1999, and most recent one from January 2012 (Romer, 2012). Similar points were also made by Taylor (2000) and Walsh (2002), but they did not deal with case of open economy. Since then, some (but very few, and mostly European) Macroeconomics textbooks have incorporated a monetary policy instead of LM function, together with an aggregate supply function derived from Phillips curve; which implies that AS-AD model is defined as a relationship between level of output and rate of inflation, instead of price level. While this has resulted in a more realistic approach, analysis has been mostly applied to closed economy. And, when open economy was introduced, its treatment has not been substantially different from closed economy case, in particular regarding aggregate supply. In this paper, we present a proposal of analysis of open economy within a framework that incorporates a monetary policy instead of LM function, extended to describe case of a monetary union. The model comes from a recently published textbook (Bajo-Rubio and Diaz-Roldan, 2011b), aimed to teach Macroeconomics at an intermediate level. We begin by examining how available Macroeconomics textbooks have dealt with depiction of monetary policy from determination of interest rate through a followed by central bank. Then, we turn to present in greater detail main features of approach followed along book, in order to extend to an open economy framework model with a monetary policy rule. MONETARY POLICY RULES IN MACROECONOMICS TEXTBOOKS As far as we know, first textbook to introduce a macroeconomic model including a monetary policy instead of an LM function is Sorensen and Whitta-Jacobsen (2010) (first edition published in 2005). In general, their approach is similar to ours, with supply side based on imperfect competition features, where workers set wages and firms set prices; and model is developed for open economy. …