Aggregate Supply and Demand in an Open Economy

Abstract

In order to explain macroeconomic behaviour in the euro area we use the simple and very conventional four equation model of the economy, consisting of an IS curve, a Phillips curve, and Okun curve and a monetary policy reaction function that we have employed earlier (Mayes and Virén, 2005) and described in outline in the previous chapter.¹ This enables us to explore the overall level of activity, inflation, unemployment and monetary policy in an open economy framework. We do not attempt to look at the determination of the exchangerate or the components of the balance of payments, nor do we consider wealth acquisition. Our model is thus incomplete. However, we are not seeking to substitute for Dynamic Stochastic General Equilibrium (DSGE) or other system approaches on this scale, we simply wish to explore the problems of asymmetry and aggregation and the concerns they pose for macroeconomic policy particularly in the EU, where single policies are implemented for member states that are quite heterogeneous.