A New Keynesian Open Economy Model for Policy Analysis

"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 in central 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 model features 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 expectations in 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.CPI inflation targeting; domestic inflation targeting; exchange rate overshooting; Mundell-Fleming model; New Keynesian open economy model; optimal monetary policy rule