In this chapter, we describe the basic framework that we use to undertake most of our analysis. In Section 3.1 we motivate our modeling assumptions and provide empirical support for these assumptions. In Section 3.2 we provide the details of the analytical model of a two-country endowment economy that we use throughout our analysis. In Section 3.3 we extend this model to allow for endogenous production decisions. Other extensions to the simple model that will be undertaken in the chapters to follow are described in Section 3.4.

Motivation for the Modeling Assumptions

Our objective is to understand the exchange rates between developed economies. We also wish to analyze the influence of financial markets on the flow of goods and financial capital between such economies, and through these flows, the effect on welfare and growth. Given these objectives, the framework we consider has the following characteristics:

1. The model is of a dynamic, stochastic, general-equilibrium world economy in which decision rules for individual agents are derived from optimizing behavior.

2. The model is one in which the economies of individual countries are distinct in that their commodity and financial markets need not be perfectly integrated.

3. Monetary policy and the exchange regime matters, in the sense that they affect the allocation of real resources.

We indicate below why these three features are important for a model used to address the issues considered in this monograph.