Monetary Policy in Small Open Economy DSGE Models: Inflation

Targeting and Sterilized Intervention

By Lawrence J. Christiano




This is a course on tools for small open-economy (SOE) macroeconomics. We will review some of the necessary technical details but primarily we will be concerned with building intuition. We will work with a model framework which allows us to address contemporary debates about monetary policy in SOEs. These debates focus on international capital flows, physical investment, sticky export prices in dollars, and balance sheet effects, especially when borrowing is done in foreign currency. We will build a model that incorporates these features and use it to discuss several policy questions: `how does inflation targeting work?’, ‘can sterilized intervention in capital markets smooth out shocks?’, ‘can sterilized intervention take the place of normal monetary policy when the effective lower bound on the interest rate becomes binding?’. How does investment, balance sheet effects, the effective lower bound on the interest rate, and sticky dollar export prices affect the answers? Using the DSGE framework allows us to be transparent about how we address these issues, and the role that our assumptions play in the answers. Also, by highlighting which assumptions are really important for designing good policy, the DSGE approach can highlight crucial areas for empirical research.


Although the Dynare code for all versions of the models will be provided, we will do Dynare in detail only with very simple examples. Eventually, as we work with more complex models, it will not be possible to go into all the technical features of MATLAB as well as Dynare that are going on in the background (however, I’m happy to discuss these things privately). Computer exercises will give students hands-on practice in the use of Dynare to solve and analyze dynamic models.


Finally, the material in this syllabus will be updated as I realize material should be added, subtracted or modified.




1) Simple Closed Economy Model.

a) Basic model construction, including sticky prices (lecture#1, lecture#1).

b) Linearizing and solving a model. More detailed notes on the Phillips curve.

c) How to answer questions like: ‘what happens if I raise the interest rate by 25 basis points for the next year?’. (At the end, will use this code to do back-of-the-envelope calculations on how to use monetary policy to stimulate a small open economy when the interest rate is stuck at its effective lower bound.)

d) Analysis of the closed economy model.

i)   Analysis the linearized model in Dynare (code for fixed interest rate exercise).

ii)Analysis of the nonlinear model in Dynare.

2) Extending the closed economy model to a very simple open economy.

a) Basic structure of the model.

b) Some properties of the model (‘Mundell-Fleming’).

3) Introducing Capital into the Model without ‘Financial Frictions’.

a) Introducing new equations into the model.

b) Properties: already starts to deviate from Mundell-Fleming.

4) Financial Frictions:

a) Costly State Verification model (Bernanke-Gertler-Gilchrist).

i)   Microeconomics

ii)Closed economy macro implications. (References: (CMRJMCB 2003AER 2014))

b) Introduce the frictions into the small open economy model with capital.

c) Balance sheet effects can have a major impact on model properties.

5) Sterilized Interventions.

a) Introduction: What are they? What are they for? Why have these experienced such an ‘up-and-down’ history and why have they now regained favor?

b) A Ricardian Equivalence Proposition for sterilized intervention: in relatively simple models, sterilized interventions are irrelevant. What does it take to make them relevant?

c) Introducing sterilized intervention policy into our model with capital and frictions.

d) Adding sticky-in-dollars export prices.

e) Do sterilized interventions provide an easy way to stimulate an economy that is in recession, when normal monetary policy is off the table because the effective zero lower bound is binding?





In addition to the material below, see this interview and this.


1.     Technical details about the subject of this course:

This is a (very) technical appendix, which goes into fine detail about the issues addressed in the course. The work summarizes ongoing research with Santiago Camara and Hüsnü Dalgic. We will not go into this level of detail in the course and I provide this only for completeness and for students who may want to dig deeper than is possible in the lectures.

2.     General Background Material about DSGE models:

a.     Christiano, Lawrence J., Martin Eichenbaum, and Mathias Tabandt, 2018, “On DSGE Models,” Journal of Economic Perspectives, Vol. 32, No. 2, (Summer), pp. 113–40.

b.     Christiano, Lawrence J., Roberto Motto, and Massimo Rostagno, 2014, “Risk Shocks,” American Economic Review, Vol. 104, No. 1, pp. 27–65.

c.     Christiano, Lawrence J., Mathias Trabandt, and Karl Walentin, 2011, “DSGE Models for Monetary Policy Analysis,” in Handbook of Monetary Economics, Vol. 3A, ed. by Benjamin Friedman and Michael Woodford (Amsterdam: Elsevier Science B.V.).

3.     Small Open Economy Models

a.     Adolfson, Malin, Stefan Laseen, Jesper Linde, and Mattias Villani, 2008, “Evaluating an Estimated New Keynesian Small Open Economy Model”, Journal of Economic Dynamics and Control, August.

b.     Christiano, Lawrence, Mathias Trabandt and Karl Walentin, “Introducing financial frictions and unemployment into a small open economy model,” Journal of Economic Dynamics and Control, 35 (2011) 1999-2041.

c.     Copaciu, Mihai, Valeriu Nalban and Cristian Bulete, 2015, “R.E.M. 2.0, An estimated DSGE model for Romania,” Dynare Working Paper Series, working paper no. 48.

d.     Christiano, Lawrence, Hüsnü Dalgic and Armen Nurbekyan, 2021, Financial Dollarization in Emerging Markets: Efficient Risk Sharing or Prescription for Disaster?”, manuscript.

4.     Sterilized Intervention

a.     Jaromir Benes, Andrew Berg, Rafael A. Portillo and David Vavra, “Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework,” Open Econ Rev (2015)

b.     Ruy Lama and Juan Pablo Medina, “Mundell meets Poole: Managing capital flows with multiple instruments in emerging economies, Journal of Money and Finance, 2020.

c.     Castillo, Paul, Juan Pablo Medina, “Foreign Exchange Intervention and the Global Financial Cycle in Emerging Economies”, manuscript.

d.     Montoro, Carlos and Marco Ortiz, 2021, The Portfolio Channel of Capital Flows and Foreign Exchange Intervention in A Small Open Economy, manuscript.