A Small Open Economy New Keynesian DSGE Model for a Foreign Exchange Constrained Economy

Abstract

Firms in many low income countries depend entirely on imported capital and intermediate inputs. As a result, in these countries economic activity is considerably influenced by the capacity of the economy to import these inputs which, in turn, depends on the availability and cost of foreign exchange. In this study we introduce foreign exchange availability as an additional constraint faced by firms into an otherwise standard small open economy New Keynesian DSGE model. The model is then calibrated for a typical Sub Saharan African economy and the behaviour of the model in response to both domestic and external shocks is compared with the standard model. The impulse responses of the two models show that the modified model generates more variability in most of the variables considered than the standard model. This behaviour of the modified model seems to correspond to the stylized facts of low income countries.