Small Open Economy DSGE Model Research Articles

Asset bubbles and financial frictions in small open economies☆

Financial cycles involving asset bubbles frequently coincide with the cyclical expansion and contraction of credit conditions. The collapse of asset and credit bubbles frequently precedes financial crises and economic recessions. We develop a small open economy DSGE model that incorporates asset bubbles and banking frictions. Credit-constrained firms trade in intrinsically useless bubble assets. Financial intermediaries, constrained by their balance sheets, introduce banking friction into financial markets. The static analysis suggests that increases in foreign interest rates unfavorably impact the formation of domestic bubbles. Dynamic analysis indicates that asset bubbles amplify macroeconomic fluctuations, with banking leverage constraints intensifying this effect. Therefore, asset bubbles amplify and propagate economic fluctuations. Unconventional monetary policy, macroprudential policy, and bubbly bailout policy could mitigate the amplification effects of banking leverage constraints and asset bubble bursts on macroeconomic fluctuations, which are mediated through reducing risk premiums, curbing capital outflows, and sustaining asset bubble channels, respectively. Finally, combining unconventional monetary policies with bubbly bailout policies and macroprudential policies yields superior outcomes.

What does housing collateral mean for Hong Kong economy? From the perspective of modelling and policy implication

This paper studies the housing sector of Hong Kong and the role of collateral constraint in modelling Hong Kong economy, through the lens of a small open economy DSGE model with a currency board exchange rate commitment. By estimating and evaluating the model by Indirect Inference over the sample period of 1994Q1–2018Q3, it is found that the collateral model can match data behaviour. Comparing with the tests generated from the model without collateral, collateral model can match the housing price data better, while the model without collateral fits the general price better. Since collateral constraint acts like an additional transmission channel, it enhances the impact from shocks and housing price is highly determined by housing demand. We further investigate LTV policy, finding it could be applied as macroprudential policy, especially when addressing the problem caused by increase in the US interest rate and the burst in the domestic housing demand, but the government should watch closely to the crowding out effect from export to housing demand and housing investment.

Technological advances in manufacturing and their effects on sectoral employment in the Korean economy

This paper studies the short- and long-term effects of rapid technological advances in the manufacturing sector (named manufacturing-specific technology shocks) on sectoral employment in the Korean economy. A study on the Korean economy is fruitful since, during deindustrialization, the country exhibited different trends from those in the United States and United Kingdom in terms of manufacturing’s share of output. Based on empirical analyses and a two-sector small open-economy DSGE model, the paper finds that over the long run, employment moves from manufacturing to services following a manufacturing-specific technology shock. In the short run, however, manufacturing employment rises. Even though the Korean economy is highly export-driven, the short-run rise in manufacturing employment is ultimately driven by an investment boom following technological innovations.

Estimation of a small open economy DSGE model for Kazakhstan

ABSTRACT This paper adapts and estimates the DSGE model of Medina and Soto (2007) in the context of Kazakhstani economy. The main goal of the paper is to contribute to the scarce macroeconomic modelling literature on Kazakhstan and analyse the structure of the Kazakhstani economy using the DSGE framework. Overall, we find that the oil price shock is key in explaining the variance of virtually all the variables of interest – in particular, it accounts for more than 40% of variance in real exchange rate over the long-term horizon. Furthermore, while the oil price and commodity (oil) production shocks contributed positively to the country’s GDP growth in real terms before the Great Recession, their effects have been primarily negative during the two major economic crises of 2007 and 2015, and the fiscal policy has had mixed success in counteracting them. Lastly, the counterfactual exercises show that the choice to adopt the floating exchange rate policy in 2015 has prevented a larger output slump in the short-term at the cost of stronger currency depreciation, and that countercyclical fiscal rules would have greatly mitigated the immediate negative impact of the 2007–08 and 2015 crises, in addition to making real output more stable overall.

Should Hong Kong switch to Taylor rule?—Evidence from DSGE model

ABSTRACT This paper studies the economy of Hong Kong through the lens of a small open economy DSGE model with a currency board exchange rate commitment. It assumes flexible prices and a banking system that provides credit to entrepreneurial household firms; the money supply is fully backed by reserves under the currency board. We estimate and evaluate the model by Indirect Inference over the sample period of 1994Q1-2018Q3; we find that it matches the data behaviour as represented by a VAR. We examined the economy’s volatility using bootstrapping of the model innovations, under both the estimated currency board model and a standard alternative regime with floating exchange rate and a Taylor rule; we found that Hong Kong welfare is higher in the currency board, which substantially reduces output volatility.

Inflation Targeting and Economic Performance: Application of the New Keynesian Small Open Economy DSGE

Bank Al-Maghrib aim to adopt the inflation targeting regime to keep pace with changes in the monetary policy environment. The challenge for the central bank is to meet the prerequisites of inflation targeting to ensure the anchoring of expectations, and thus achieve the inflation target and real stability.
 The objective of this paper is to propose an optimal model for Morocco's successful transition to inflation targeting.
 To do so, we build a New Keynesian Small Open Economy DSGE model, characterized by financial frictions, imperfect exchange rate pass-through, unemployment, fiscal rule and new shocks. The results of our simulations lead us to assert that it would be wise to choose the most complete model, since it provides credibility, stability and growth.
 Keywords: anchoring expectations, inflation targeting, economic growth, DSGE, financial frictions.

Risky Mortgages and Macroprudential Policy: A Calibrated DSGE Model for Lithuania

Following the financial crisis of 2009 there was an emergence of macroprudential policy tools, as well as a need to model the macroeconomy and the financial sector in a coherent framework. This paper develops and calibrates a small open economy DSGE model for Lithuania to shed some light on the interactions between the macroeconomy and the banking sector, regulated by macroprudential policy. The model features housing market, and endogenous credit risk a la de Walque et al. (2010), whereby the household can default on mortgage repayments, what leads to housing collateral seizure. Foreign-owned banks, that are subject to risk-sensitive macroprudential capital requirements, take into account not only the mortgage default rate but also the cap on loan to value (LTV) ratio when making lending decisions. Using this mechanism, we show that while a more stringent LTV constraint reduced credit demand, it can also lead to an expansion in credit supply via lower credit risk. Therefore, a tightening of LTV requirement should result in only a slight reduction in mortgage lending, coupled with lower interest rate margins. The article compares the impact of the tightening of three macroprudential tools, namely, bank capital requirements, mortgage risk weights and LTV limit. We find that broad-based capital requirements, such as the counter-cyclical capital buffer, are less efficient in leaning against the housing credit cycle, because of a relatively large cost incurred on the firm sector.

Business cycle fluctuations in Taiwan — A Bayesian DSGE analysis

This paper examines the Taiwanese economy in a small open economy DSGE model using Bayesian estimation. The model consists of two countries and 12 exogenous shocks with stochastic volatility to capture the fluctuations in the business cycle. The main results are: (1) shock innovations with stochastic volatility increase the model fit, (2) shocks originated from outside the country are important sources of fluctuations in the Taiwanese business cycle.

Asymmetric Effects of Monetary Policy on the Armenian Economy

Whether inflation and output respond symmetrically or asymmetrically to the same size of contractionary and expansionary monetary policy shock has important policy implications. This paper shows the presence of asymmetric responses in Armenian inflation and output to positive and negative monetary policy shocks of the same size by employing econometric models. Contractionary policy decreases inflation less than expansionary policy increases it. Output reacts in the opposite way. An estimated small open economy DSGE model with sticky wages and investment adjustment costs explains about half of the asymmetry observed in the monetary policy transmission mechanism. This paper finds that the main part of inflation reaction asymmetry is a result of a highly convex Phillips curve for the importers. The nonlinearities of the internal economy explain the predominant part of the asymmetry in output reaction.

Should monetary policy lean against the wind in a small-open economy? Revisiting the Tinbergen rule

Abstract While conventional monetary policy maintains its role in counteracting inflation, there are doubts that it is sufficient to guard against the risks of financial instability. It has been debated whether monetary policy should lean against the wind, i.e., if central banks should also respond to the build-up of financial imbalances, such as those associated with unsustainable credit expansion. In the spirit of the Tinbergen rule, some authors have claimed that monetary policy is ineffective in achieving price and financial stability simultaneously. However, others have argued that monetary policy could play a role in taming the credit cycle without compromising its effectiveness to control inflation efficiently. Until now, this analysis has been mostly carried out in a closed-economy setting. I contribute to the debate by showing that targeting the two policy objectives with a single instrument is more costly for a small-open economy than for a closed one. To this end, I develop a small-open economy DSGE model with the Bernanke-Gertler-Gilchrist financial accelerator that features financial frictions and monopolistic competition in goods markets. I then estimate this model for Mexico to explore the policy regimes yielding the lowest welfare cost. My main finding is that the Tinbergen rule is alive and well: Leaning against the wind or augmenting the Taylor rule with an argument on credit growth is not an optimal policy response; instead, the optimal policy mix consists of using two separate tools that focus each on price and financial stability. At the same time, these instruments complement each other to stabilize the economy under financial shocks. Nevertheless, macroprudential measures may not be as useful in helping economic stability under different shocks, particularly when a productivity shock hits the economy. In addition, my model is useful to gauge macroprudential measures effectiveness when discriminating against foreign liabilities. In this regard, I find that macroprudential measures that consider both internal and external debt are more effective than capital controls.

Long-term implications of oil discoveries for international saving in a DSGE model

Possession and production of oil reserves affects the host country’s current account. Throughout the history of the North Sea oil, Norway ran persistent current account surpluses and accumulated public “oil funds.” The other major producer, the United Kingdom did not establish an oil fund. This work models how oil discoveries impact the current account. A small open economy DSGE model with an oil sector expresses the current account as a function of oil discoveries. In this model, an oil discovery creates a long-term borrowing-repayment-saving cycle. Some of the characteristics of the economy that affect oil-related decisions include: the presence of an oil fund, the equity home bias, and the technology of the oil industry. These characteristics are estimated structurally using the North Sea data for Norway and the United Kingdom. The estimation suggests that, upon discovering oil in the North Sea, the populations of Norway and the United Kingdom made similar economic choices but under different circumstances: Norway’s export revenues were amplified by a period of high oil prices in the 2000s, whereas the UK largely balanced its oil trade and did not benefit from the oil price. Similar decisions made under different circumstances led to remarkably different effects of oil discoveries on the current accounts.

The euro area periphery and imbalances: Is it an Anticipation Story?

This paper investigates the sources of the current account (CA) imbalances experienced within the euro area periphery (Greece, Ireland, Portugal and Spain) before the Great Recession by assessing the role played by anticipated shocks. Since 1996, before the actual introduction of the euro, widening of CA deficits occurred in countries with appreciating real exchange rates and output growing faster than trend. To understand the causes of these patterns, I develop and estimate a small open economy DSGE model encompassing plausible drivers of CA imbalances. Anticipated spread convergence, and not catching-up, caused euro area periphery imbalances. Quantitatively, anticipated shocks are important drivers of CA and real exchange rate fluctuations.

Search frictions and the business cycle in a small open economy DSGE model

A labor market specification featuring search frictions and unemployment within an otherwise standard New Keynesian small open economy model significantly improves its ability to explain and predict both labor market data and other macroeconomic variables. We estimate the model with Chilean data and find that variations along the extensive margin of labor supply (i.e., employment) play a crucial role in the propagation of shocks, whereas the intensive margin (i.e., hours) is not important. Furthermore, foreign shocks are the key drivers of the business cycle, which is consistent with the empirical literature on open emerging economies. We conclude that a medium-scale DSGE model with this richer labor market specification is superior to one featuring the standard assumption of a labor market that always clears at a sticky nominal wage (à la Calvo) through variations along the intensive margin.

Should a central bank react to food inflation? Evidence from an estimated model for Chile

We examine whether food price shocks are a major source of macroeconomic fluctuations. We estimate a small open economy DSGE model using an alternative Taylor rule applied to Chilean data. The empirical evidence suggests that food inflation played a non-trivial role in shaping Chile's de facto monetary policy actions. Consistent with its commitment to price stability, the central bank increases the policy rate in reaction to food inflation. Despite an immediate monetary policy reaction to a food price shock, the policy rate gradually tapers off. This is due to a second-round effect on non-food inflation propagated by the food price shock. A main finding is that monetary policy that targets headline inflation is welfare improving.

Winners and losers of central bank foreign exchange interventions

Interventions in foreign exchange markets are indispensable for most central banks and recent years have witnessed an increase in their frequency and magnitude. However, little is known about their implications on agents’ welfare. This paper investigates the topic by employing a small open economy DSGE model with savers and borrowers in both local and foreign currencies, where the central bank intervenes to smooth out exchange rate volatility by changing its foreign reserve. Interventions occur following the foreigners’ decision to sell (or buy) domestic assets, thus weakening (or strengthening) the local currency. The model allows the disentanglement of welfare implications by type of agent and source of exchange rate imbalance, which is novel in the literature, providing useful insight for central bankers. The findings highlight the benefits of interventions in the case of foreign financial shocks, especially when the level of currency mismatch in the economy is high. However, when exchange rate disequilibrium stems from domestic developments, the intervention generates winners and losers.

미국 통화정책이 한국 경제에 미치는 영향 분석을 위한 소규모 개방경제 DSGE 모형 추정에 관한 연구

본 연구는 Christiano et al.(2011)에서 소개된 소규모 개방경제 동태적 확률일반균형 모형(a small open economy dynamic stochastic general equilibrium(DSGE) model)을 미국 통화정책이 한국 경제에 미치는 영향을 분석하기 위한 틀로 제시하고, 2000년 1분기부터 2017년 4분기까지의 한국과 미국 데이터를 이용하여 추정하였다. 본 모형의 추정 결과로 얻은 모형의 파라미터들의 값들(estimated structural parameter values)은 기존 연구들의 추정 값들과 유사하며, 미국과 국내 통화충격을 포함한 추정된 모형의 충격들(estimated structural shocks)은 직관적으로 설명되는 거시경제변수들(예를 들어, 국내총생산, 소비, 노동시간, 실질환율, 순수출)의 충격반응함수들을 도출하는 것으로 확인되었다.

Financial Frictions and Shocks in an Estimated Small Open Economy DSGE Model

This paper examines the importance of financial frictions and shocks for macroeconomic fluctuations using an estimated small open economy DSGE model. In doing so, a small open economy DSGE model with unemployment, financial frictions and financial shocks is developed. To quantify effects, the model is estimated using Bayesian methods on Australian and the United States (US) data. The main results are (i) the presence of financial accelerator improves the model fit, and (ii) financial shocks (i.e., credit supply and financial wealth shocks) are important for explaining investment and output fluctuations, (iii) including financial data in the analysis changes the model dynamics and influences the significance of the financial and marginal efficiency of investment (MEI) shocks, and (iv) financial shocks play an important role in generating business cycle fluctuations in both Australia and the US.

How important are the international financial market imperfections for the foreign exchange rate dynamics: A study of the sterling exchange rate

The UK has been a net debtor over the past two decades and the sterling exchange rates are sensitive to any chaos that might occur in the financial market. This paper examines the importance of the international financial imperfections in the sterling exchange rate dynamics. We build a small open economy DSGE model with the constrained international financial institutions that intermediate capital flows, and derive tractable analytical solutions. The constraint works to introduce a wedge between lending and borrowing rates, which compensates financiers for their currency risk-taking. The model has been estimated by using a simulation-based Indirect Inference approach, which provides a natural framework for testing the hypothesis implied by the model. We find that the model cannot be rejected by the UK data. Shocks to financial forces are the main driving forces behind the large and sudden depreciation of the Sterling exchange rates in the aftermath of the collapse of Lehman Brothers and the Brexit vote. Furthermore, the optimal policy rules have been proposed.

FIR-GEM: A SOE-DSGE Model for Fiscal Policy Analysis in Ireland

This paper presents FIR-GEM: Fiscal IRish General Equilibrium Model. FIR-GEM is a small open economy DSGE model designed as fiscal toolkit for fiscal policy analysis in Ireland. To illustrate the model's potential for fiscal policy analysis, we conduct three types of experiments. First, we analyse the fiscal transmission mechanism through which Irish fiscal policy affects the Irish economy. Second, we compute fiscal multipliers for the main tax-spending instruments, namely government consumption, public investment, public wage bill, public transfers, consumption, labour and capital tax. We focus on a fiscal policy stimulus that is either implemented through spending increases or tax cuts. Third, we perform robustness analysis on key structural characteristics that can affect quantitatively the size of fiscal multipliers. We find that the size of fiscal multipliers in the Irish economy heavily depends on its degree of openness, the method of fiscal financing employed, the elasticity of the sovereign risk premia to Irish debt dynamics and the flexibility of Irish labour and product markets.

On the Relationship Between Domestic Saving and the Current Account: Evidence and Theory for Developing Countries

We examine the relationship between domestic saving and the current account in developing countries. Our three main findings are that domestic saving has: (i) a small effect on the current account; (ii) a significant positive and quantitatively sizable effect on the trade balance; (iii) a significant negative effect on net-current transfers. We use countries in the sub-Saharan African region as a laboratory for an instrumental variables approach. The IV approach enables to obtain estimates of causal effects. Underlying the IV approach is the significant positive first-stage response of domestic saving to plausibly exogenous annual rainfall: an unanticipated, transitory supply-side shock. We construct a small open-economy DSGE model with debt adjustment frictions and endogenous net-current transfers to match the empirical findings. The model enables to examine how other types of shocks - such as changes in interest rates or trend TFP for which it is hard to get exogenous variation in the data - affect the relationship between domestic saving and the current account. An important implication of our findings is that, for developing countries, estimates of the relationship between domestic saving and domestic investment are not informative for answering the question how domestic saving affects a country's accumulation of net foreign assets.