A SMALL OPEN ECONOMY WITH STAGGERED WAGE SETTING AND INTERTEMPORAL OPTIMIZATION: THE BASIC ANALYTICS by JOHN FENDER University of Birmingham and NEIL RANKIN * University of Warwick We develop a model of a small open economy with optimizing, infinitely lived agents. They have monopoly power over the price of their labour, and wage setting is staggered. We consider the effects of an unanticipated increase in the money supply. In all cases, the exchange rate depreciates immediately to its long-run value with no overshooting. With unitary elasticity of substitution in preferences between home and foreign goods, output rises instantaneously but gradually returns to its initial value in the long run. Trade remains balanced at all times. With an elasticity of substitution above unity, there is a trade surplus in the short run and a deficit in the long run, as permanently higher net foreign assets are accu- mulated. Convergence to the steady state is faster, and thus output per- sistence is smaller. With unitary elasticity the dynamics are the same as in an equivalent closed economy, so, to the extent that an elasticity greater than one is plausible for an open economy, we conclude that openness reduces output persistence. 1 I  There seems to be an emerging consensus that any satisfactory theoretical macroeconomic model must contain (at least) three elements: (1) intertem- poral optimization; (2) imperfect competition; (3) nominal rigidities (see, for example, Blanchard, 1997). We do not discuss this issue at length here, but would merely make the following points. A strong case can be made for assuming intertemporal optimization; it ensures that agents respect budget constraints and allows us to analyse rigorously, for example, how future (anticipated) events affect current economic behaviour, something often lacking in models based on ad hoc behavioural assumptions. Nominal rigidi- ©Blackwell Publishing Ltd and The Victoria University of Manchester, 2003. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK, and 350 Main Street, Malden, MA 02148, USA. 396 The Manchester School Vol 71 No. 4 Special Issue 2003 1463–6786 396–416 *The paper was presented at seminars at the University of Oregon, USA, and at the University of Birmingham, UK, to the Conference on Growth and Business Cycles in Theory and Practice, University of Manchester, in June 2002 and at the Anglo-French Macroeconom- ics Workshop at University College, Oxford, in January 2003. We would like to thank par- ticipants, two anonymous referees and Jean-Pascal Benassy (our discussant at the Oxford Workshop) for helpful comments.