Monetary Policy in Small Open Economy DSGE Models: Inflation

Targeting and Sterilized Intervention

By Lawrence J. Christiano

**Overview**

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 `dollars’ (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?’. The answers to these questions
are heavily determined by the assumptions built into models and DSGE models
allow you to make that dependence clear. Such models also force one to be
transparent about the assumptions being made. Transparency promotes
communication between researchers. 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.

**Lectures**

1) Simple Closed Economy Model.

a) Basic
model construction, including sticky prices (annotated
slides).

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

c) An important feature of any DSGE
model with concave preferences in consumption: consumption
smoothing.

d) Analysis of the closed economy model.

i) Analysis
of the linearized model in Dynare. (Notes
on putting Natural Rate into the Taylor rule.)

ii) Analysis
of the nonlinear model in Dynare.

e) Extra material:

i) Deeper discussion of first order perturbation (connection to Blanchard-Kahn
conditions, sunspots, others exotic things).

ii) Using the linearization solution strategy to demonstrate important properties of the model analytically: (a)
Fisherian versus anti-Fisherian properties of the model, (b) Erceg and Levin’s
use of a blend of these two properties of the model to explain the sacrifice
ratio in the Volcker disinflation, (c) analytic demonstration of the ‘forward
guidance puzzle’, (d) analytic demonstration of the property of the Taylor
rule, that it is responds to ‘weakly’ but in the right direction to a `normal’
(not news) shock.

2) Extending
(annotated
version)the closed economy model to a very simple open economy. (Code for
all the versions of the small open economy is here. Use at own risk!)

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).

ii) Closed economy macro
implications. (References: (CMR, JMCB 2003, AER 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.

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?

Readings

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

**Close Economy DSGE Modeling:**

1)
Christiano, Lawrence J., Martin Eichenbaum, and Mathias Tabandt, 2018, “On DSGE Models,” *Journal
of Economic Perspectives*, Vol. 32, No. 2, (Summer), pp. 113–40.

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

3) 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.).

**Open Economy DSGE Modeling:**

4) 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.

5)
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.

**Open Economy DSGE Modeling
with Sterilized Interventions:**

6)
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)

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

8) (Very)
technical appendix,
addressing sterilized intervention in DSGE models. We will *not* go into
this level of detail in the course. This is joint work with Santiago Camara and
Hüsnü Dalgic.

**Empirical Analysis Related to
Sterilized Interventions:
**

9) Adler and Tovar (2011); Hnatkovska, et. al. (2016); Fratzscher, et. al. (2019); Gómez, et. al. (2020); Lu, et. al. (2022); Brandao-Marques, et. al. (2020); Mohanty and Berger (2014); Naef and Weber (2021); Scalia (2008).

10) Failure of UIP: Chinn and Meredith (2005) and Chinn and Quayyum (2012).