Open Economy DSGE Model Research Articles

Estimation of the New Keynesian Phillips Curve in the Czech Environment

The paper deals with the estimation of the New Keynesian Phillips curve (NKPC). First, the history of the Phillips curve and the NKPC is outlined. Next, similar research and papers regarding the NKPC are mentioned. The main goal of the paper is to estimate the parameters of the NKPC using the Bayesian techniques. These techniques are widely used for the DSGE model estimation and this paper contains links to the source foreign literature. The NKPC is estimated as part of a fully calibrated Small Open Economy (SOE) DSGE model. The SOE DSGE model consists of households, firms, the government and the central bank. The estimation is performed on the Czech data and the period is from 2001Q1 to 2012Q2. The first output of the paper is the parameter estimates of the NKPC. The main finding is that the future expected inflation plays a crucial role in setting the level of inflation. Moreover, a shock decomposition of domestic and imported inflation is performed and the main output is that the domestic monetary policy shock causes crucial changes in the level of both domestic and imported inflation.

The Sources of Recent Inflation in Vietnam: Evidence from a VAR with Sign Restrictions

This paper studies the sources of high and chronic inflation in Vietnam in recent years using the structural VAR method identified by sign restrictions. The novelty of the paper is that the sign restrictions are drawn from a New Keynesian small open economy DSGE model built and calibrated to the data of Vietnam. Variance decomposition results show that supply shocks and demand shocks seem to explain a large part of inflation over the whole sample period, while the contribution of monetary shocks is much smaller but not negligible. Historical decomposition results show that demand shocks and, to a lesser extent, monetary shocks seem to be the main determinants of inflation in the period 2004Q1-2008Q3, while supply shocks appear to be more important in the period 2008Q1-2010Q4.

THE TIMING OF ASSET TRADE AND OPTIMAL POLICY IN DYNAMIC OPEN ECONOMIES

Using a standard open economy DSGE model, it is shown that the timing of asset trade relative to policy decisions has a potentially important impact on the welfare evaluation of monetary policy at the individual-country level. If asset trade in the initial period takes place before the announcement of policy, a national policy maker can choose a policy rule that reduces the work effort of households in the policy maker's country, in the knowledge that consumption is fully insured by optimally chosen international portfolio positions. But if asset trade takes place after the policy announcement, this insurance is absent and households in the policy maker's country bear the full consumption consequences of the chosen policy rule. The welfare incentives faced by national policy makers are very different between the two cases. Numerical examples confirm that asset-market timing has a significant impact on the optimal policy rule.

Comparing monetary policy rules in CEE economies: A Bayesian approach

Using the Bayesian approach, a small open economy DSGE model was estimated using a sample of quarterly data for three Central and Eastern Europe economies, Czech Republic, Hungary and Poland. The hypothesis that central banks react to exchange rate movements was tested using posterior odds ratio. For these economies, evidence was found that central banks reacted to exchange rate changes. Evidence of similar monetary policy characterized by moderate or low gradualism as well as an active and conservative monetary policy was also found, for the selected countries. When a richer DSGE model featuring habit formation and imperfect pass-through is estimated, the results are generally similar. The inclusion of exchange rate in Taylor rule can also drastically change the dynamics of inflation and output following certain shocks.

Estimating a small open economy DSGE model with indeterminacy: Evidence from China

Considering that monetary policy instability may cause indeterminacy of the macroeconomic equilibrium, this paper derives the boundary condition between determinacy and indeterminacy in a small open economy DSGE model, and then uses this model to investigate China's monetary policy and macroeconomic fluctuations under indeterminacy during the period from 1992 to 2011. The empirical results show that the nominal interest rate reacts not only to inflation and output gap, but also to the changes in RMB exchange rate. Moreover, the indeterminacy in the macro-dynamics indicates the instability in China's monetary policy, and it stems from two sources, the sunspot shock and the indeterminate propagation of fundamental shocks. In addition, we find that the monetary policy shock affects macroeconomic dynamics significantly in the short run, while in the long run, it only influences nominal variables, such as the inflation and the exchange rate, but not the real output.

Expected Regime Change: Transition toward Nominal Exchange Rate Stability

This work presents an extension of a small open economy DSGE model allowing the transition toward a monetary policy regime aimed at exchange rate stability to be described. The model is estimated using the Bayesian technique to fit the properties of the Czech economy. In the scenarios assessed, the monetary authority announces and changes its policy so that it is focused solely on stabilizing the nominal exchange rate after a specific transition period is over. Four representative forms of monetary policy are followed to evaluate their properties over the announced transition period. Welfare loss functions assessing macroeconomic stability are defined, allowing the implications of the transition period regime choice for macroeconomic stability to be assessed. As these experiments show, exchange rate stabilization over the transition period does not deliver the lowest welfare loss. Under the assumptions taken, the strict inflation-targeting regime is identified as the best-performing regime for short transition periods. However, it can be concluded that for longer transition periods the monetary policy regime should respond to changes in the exchange rate.

Housing prices and the business cycle: An empirical application to Hong Kong

This paper develops a two-agent, two-sector, open-economy DSGE model with a housing-market sector and a borrowing constraint. Contrary to standard conventions, domestic households are allowed to invest in foreign housing and vice versa. Using Bayesian methods, the model is applied to data for Hong Kong. We identify strong and robust housing wealth effects, and show that property prices are mainly driven by intratemporal preference perturbations rather than by disturbances in financial frictions or price mark up shocks. These disturbances also explain a non-negligible part of the volatility of consumption, GDP and employment.

The interaction between monetary and fiscal policies in Turkey: An estimated New Keynesian DSGE model

This paper estimates a New Keynesian open economy DSGE model for Turkey by using Bayesian estimation technique for the period of 2002:q1–2009:q3. It studies fiscal and monetary policy interactions and their role in stabilisation of the economy using a small-scale model following the methodology outlined in Lubik and Schorfheide (2007). The general features of the model can be summarised as follows: Calvo style nominal price rigidities, perfect exchange rate pass-through, complete international asset markets, rule of thumb price setters and distortionary taxation.The parameter estimates show that the monetary authority reacts to inflation but only weakly reacts to the output gap. The degree of interest rate smoothing is high. Fiscal policy has contributed to the debt stabilisation but there is no evidence on active fiscal stabilisation of output gap.

Exchange-Rate Dark Matter

Dark matter is believed to account for 83 percent of the matter in the universe and plays a central role in cosmology modeling. This paper argues that an analogous form of dark matter plays a similarly important role in international macroeconomics. Like its cosmological counterpart, exchange-rate dark matter cannot be directly observed, but its existence can be inferred from observations on the real exchange rates and interest rates. In the first part of this paper I show that dark matter is the dominant driver of short- and medium-term changes in real exchange rates for the G-7 countries; accounting for more than 90 percent of the variance at the five-year horizon. Although standard models stress the role of real interest differentials as the proximate drivers of real exchange-rate variations, my findings indicate that they are empirically unimportant.To understand the nature of exchange-rate dark matter, the second part of the paper develops an open-economy DSGE model in which the risk shocks driving households’ habits interact with collateral constraints and incomplete markets. The model not only shows that risk shocks can account for the role of dark matter as a driver of real exchange-rate dynamics, but also that these same shocks have significant macroeconomic implications. My analysis suggests that exchange rates appear disconnected from traditional macroeconomic fundamentals because they are particularly susceptible to risk shocks that play an important role in international macroeconomics.

Would it Have Paid to Be in the Eurozone?

Giving up an independent monetary policy and a flexible exchange rate are the key sources of costs and benefits entailed to joining a monetary union. In this paper we analyze their ex post impact on the stability of the Polish economy during the recent financial crisis. To this end we construct a small open economy DSGE model and estimate it for Poland and the euro area. Then we run a counterfactual simulation, assuming Poland’s euro area accession in 1q2007. The results are striking - volatilities of GDP and inflation increase substantially. In particular, had Poland adopted the euro, GDP growth would have oscillated between -6% and 9% (-9% to 11% under more extreme assumptions) instead of between 1% and 7%. We conclude that during the analyzed period independent monetary policy and, in particular, the flexible exchange rate played an important stabilizing role for the Polish economy.

Disaggregating Real Exchange Rate Dynamics: A Structural Approach

This paper employs a small open economy DSGE model, estimated over 19862009, to decompose the dynamic in‡uence of domestic and international prices on the Canada-US real exchange rate. While the real exchange rate mimics the dynamic behavior of the relative price of non-tradables in terms of tradables in response to a non-tradable sector-speci c disturbance, the purely tradable component dominates in the case of other shocks, irrespective of their structural origin. Variance decompositions reveal that the sources of the movements in the tradable component lie in unsystematic deviations from uncovered interest parity as well as import price mark-up shocks. Consequently, these disturbances are far more potent than internal tradable or non-tradable sector-speci c disturbances in driving real exchange rate ‡uctuations. JEL classi cation: C11, F41 Keywords: New Open Economy Macroeconomics, Small Open Economy, NonTradables, Canada-US Real Exchange Rate, Bayesian Estimation. I acknowledge nancial support from the Inter-University Attraction Poles Program-Belgium Science Policy (Contract Number P6/07) and the Flemish Fund for Scienti c Research (FWO). I also thank Nicholas Groshenny, Robert Kollmann, Vivien Lewis, Gert Peersman, Ine Van Robays, Roland Straub, Raf Wouters and seminar participants at the Reserve Bank of New Zealand for helpful suggestions. All remaining errors are mine.

An Estimated Dynamic Stochastic General Equilibrium Model for the Romanian Economy, Considering Nominal and Real Rigidities

This paper is meant to render the estimation, for Romania, of an open economy DSGE model, grounded on the new Keynesian thinking, that is, considering monopolistic competition and nominal and real rigidities. The analysis implies the calibration of certain parameters, based on accepted literature in the matter and on pertinent information for the related economy, on one hand, and the estimation of the remainder of parameters, by resorting to Bayes theorem, on the other hand. Once the posterior probabilities are determined, the results interpretation and relevance is discussed from an economic perspective.

Business cycles through international shocks: A structural investigation

This paper investigates the sources of output volatility by decomposing the international shocks into finance and trade shocks. Through structural Bayesian estimations of an open-economy DSGE model on 16 countries, on average, international shocks explain around 70% of output fluctuations.

Parameter Identification in an Estimated New Keynesian Open Economy Model

In this paper, we use Monte Carlo methods to study the small sample properties of the classical maximum likelihood (ML) estimator in artificial samples generated by the New-Keynesian open economy DSGE model estimated by Adolfson et al. (2008) with Bayesian techniques. While asymptotic identification tests show that some of the parameters are weakly identified in the model and by the set of observable variables we consider, we document that ML is unbiased and has low MSE for many key parameters if a suitable set of observable variables are included in the estimation. These findings suggest that we can learn a lot about many of the parameters by confronting the model with data, and hence stand in sharp contrast to the conclusions drawn by Canova and Sala (2009) and Iskrev (2008). Encouraged by our results, we estimate the model using classical techniques on actual data, where we use a new simulation based approach to compute the uncertainty bands for the parameters. From a classical viewpoint, ML estimation leads to a significant improvement in fit relative to the log-likelihood computed with the Bayesian posterior median parameters, but at the expense of some the ML estimates being implausible from a microeconomic viewpoint. We interpret these results to imply that the model at hand suffers from a substantial degree of model misspecification. This interpretation is supported by the DSGE-VAR (lambda) analysis in Adolfson et al. (2008). Accordingly, we conclude that problems with model misspecification, and not primarily weak identification, is the main challenge ahead in developing quantitative macromodels for policy analysis.

Credit crunch in a small open economy

We construct an open-economy DSGE model with a banking sector to analyze the impact of the recent credit crunch on a small open economy. In our model the banking sector operates under monopolistic competition, collects deposits and grants collateralized loans. Collateral effects amplify monetary policy actions, interest rate stickiness dampens the transmission of interest rates, and financial shocks generate non-negligible real and nominal effects. As an application we estimate the model for Poland–a typical small open economy. According to the results, financial shocks had a substantial, though not overwhelming, impact on the Polish economy during the 2008/09 crisis, lowering GDP by approximately 1.5 percent.

Monetary policy and the exchange rate: Evaluation of VAR models

This paper examines the ability of vector autoregressive (VAR) models to properly identify the transmission of monetary policy in a controlled experiment. Simulating data from a small open economy DSGE model estimated for Australia, we find that sign-restricted VAR models do reasonably well at estimating the responses of macroeconomic variables to monetary policy shocks. This is in contrast to models that use recursive zero-type restrictions, for which inflation can rise following an unexpected interest rate increase while the exchange rate can appreciate or depreciate depending on the ordering of the variables. Sign-restricted VAR models seem to be able to overcome puzzles related to the real exchange rate, provided that a sufficient number of different types of shocks are identified. Despite delivering the correct sign of the impulse responses, central tendency measures of sign-restricted VAR models can, however, be misleading and hardly ever coincide with the true impulses. This finding casts doubt on the common notion that the median impulses are the ‘most probable’ description of the true data-generating process.

Financial Factors in the Boom-Bust Episode in Finland in the Late 1980s and Early 1990s

This paper proposes a framework for studying the boom and bust in Finland in the late 1980s and early 1990s. We develop a small open economy DSGE model with balance sheet-constrained firms a la BGG and calibrate it to the Finnish economy. We use the model to simulate three events that are claimed to have played a key role in the Finnish boom-bust episode and compare the model outcome with actual Finnish data. Firstly, we assess in our DSGE framework the role of financial market deregulation in the 1980s in the boom that preceded the crises. Secondly, we use our model to evaluate the negative impact of the collapse of Soviet-Finnish trade at the beginning of 1991. Thirdly, we investigate the effect of the collapse of the fixed exchange rate regime in September 1992. We conclude that financial frictions combined with the shocks that hit the Finnish economy are able to produce a boom and a severe depression similar to the one observed in Finland in the late 1980s and early 1990s. A key finding is the crucial role played by the financial accelerator mechanism in the ability of the model to mimic the response of the Finnish economy to the shocks it encountered. A key contribution is the incorporating unconventional shocks into the model: domestic financial market shocks to capture the deregulation of the financial market; a capital obsolescence shock to model the sudden redundancy of Soviet-oriented manufacturing; and a shock from the international financial market, a country borrowing premium shock, to capture the collapse of the fixed exchange rate regime.

Credit Crunch in a Small Open Economy

We construct an open-economy DSGE model with a banking sector to analyse the impact of the recent credit crunch on a small open economy. In our model the banking sector operates under monopolistic competition, collects deposits and grants collateralized loans. Collateral effects amplify monetary policy actions, interest rate stickiness dampens the transmission of interest rates, and financial shocks generate non-negligible real and nominal effects. As an application we estimate the model for Poland - a typical small open economy. According to the results, financial shocks had a substantial, though not overwhelming, impact on the Polish economy during the 2008/09 crisis, lowering GDP by approximately 1.5 percent.

Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses

The resumption of capital flows to emerging market economies since mid 2009 has posed two sets of interrelated challenges for policymakers: (i) to prevent capital flows from exacerbating overheating pressures and consequent inflation, and (ii) to minimize the risk that prolonged periods of easy financing conditions will undermine financial stability. While conventional monetary policy maintains its role in counteracting the former, there are doubts that it is sufficient to guard against the risks of financial instability. In this context, there have been increased calls for the development of macroprudential measures, with an explicit focus on systemwide financial risks. Against this background, this paper analyses the interplay between monetary policy and macroprudential regulations in an open economy DSGE model with nominal and real frictions. The key result is that macroprudential measures can usefully complement monetary policy. Even under the optimal policy, which calls for a rather aggressive monetary policy reaction to inflation, introducing macroprudential measures is found to be welfare improving. Broad macroprudential measures are shown to be more effective than those that discriminate against foreign liabilities (prudential capital controls). However, these measures are not a substitute for an appropriate moneraty policy reaction. Moreover, macroprudential measures are less useful in helping economic stability under a technology shock.

Oil Shocks through International Transport Costs: Evidence from U.S. Business Cycles

The effects of oil shocks on output volatility through international transport costs are investigated in an open-economy DSGE model. Two versions of the model, with and without international transport costs, are structurally estimated for the U.S. economy by a Bayesian approach for moving windows of ten years. For model selection, the posterior odds ratios of the two versions are compared for each ten-year window. The version with international transport costs is selected during periods of high volatility in crude oil prices. The contribution of international transport costs to the volatility of U.S. GDP has been estimated as high as 36% during periods of oil crises.