Abstract

AbstractWe build four different dynamic stochastic general equilibrium (DSGE) models for a small open economy reflecting both neoclassical and Keynesian specifications. A DSGE model with full price and wage flexibility is initially constructed and then modified through nominal wage and price rigidities. The ability of the models to replicate important features of the business cycle activity in the UK is explored through statistical and econometric analysis. Evidence suggests that a monetary shock under the Taylor model with price stickiness can replicate a significant portion of the business cycle activity in the UK economy.

Highlights

  • This paper compares the predictions of several dynamic stochastic general equilibrium (DSGE) models with a view to developing an improved understanding of observed fluctuations in small open economies

  • Since the various theoretical predictions of the neoclassical models have triggered researchers to question their appropriateness to replicate data well, we examine the empirical implications of the neoclassical model in relation to the UK economy

  • This paper has constructed and analysed four different dynamic stochastic general equilibrium models in order to investigate the dynamic effects of a small open economy within both neoclassical and Keynesian economic environments

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Summary

INTRODUCTION

This paper compares the predictions of several dynamic stochastic general equilibrium (DSGE) models with a view to developing an improved understanding of observed fluctuations in small open economies. The model reflects a small open economy, which consists of an optimizing representative agent, who holds both domestic and foreign assets, together with the fiscal and monetary branches of the government, and production and foreign sectors. The novelty of our approach is to introduce a dynamic stochastic general equilibrium model with rational expectations and overlapping labour contracts within the small open economy framework after modifying the benchmark neoclassical model. This is achieved after introducing a variant of Taylor’s (1979) overlapping contract mechanism into a dynamic stochastic modelling, assuming that a proportion of decision makers (firms-unions) negotiate a nominal contract wage growth, which last for two subsequent periods. There is a monetary and a fiscal branch of the government, a foreign sector, and an aggregate production technology for domestic firms

The households
Domestic firms
The Government
The monetary authority
The foreign sector
The economy wide resource constraint
Model variation Ι
New Keynesian models with price stickiness
Model variation II
Model variation III
THE SOLUTION TO THE NEW KEYNESIAN MODELS
Models’ parameterization
The Neoclassical model
The Keynesian model with wage stickiness
The new Keynesian models with price stickiness
THE EMPIRICAL IMPLICATIONS OF THE MODELS
Simulated business cycles for the British Economy
Testing the long-run empirical validity of the economic modelling
TEST THE SHORT RUN DYNAMIC PREDICTIONS OF THE MODELS
Dynamic responses to a monetary shock
Dynamic responses to a fiscal shock
Dynamic responses to a technology shock
Findings
CONCLUSION AND IMPLICATIONS

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