Asymmetry, terms of trade and the aggregate supply curve in an open economy model

Abstract

A new Keynesian monetary policy DSGE model estimated for an emerging and an advanced economy (India and the US) gives deep parameter estimates, impulse responses and forecast error variance decompositions for each in line with theory and country structure, implying similar functional forms can be estimated for differing countries with estimated coefficients capturing differences in structure. Features that create excess volatility, especially in emerging markets, explain differences in policy shocks. The feature explored in this paper is external terms of trade. When this is dampened in the emerging market, using policy tools other than the policy rate, the aggregate supply curve, which was relatively steeper, becomes flatter. As a result volatility of interest rates and their impact on output and inflation, which was relatively higher in India, becomes lower than in the US. Asymmetries between the countries are reversed. The estimated coefficient of the terms of trade is relatively higher in the US Taylor rule, while emerging market central banks find other policy tools more effective to manage external terms of trade.