Open Economy DSGE Models

By Lawrence J. Christiano

  

 

Overview

 

We will build a small open economy model from scratch, beginning with the simplest closed economy with no capital. We’ll go step by step, starting by opening the closed economy, then introducing capital, then balance sheet constraints, and finally, FX interventions and dollar export pricing.

 

The course has two objectives: to convey exciting new ideas in international macro and to convey the essentials of model construction and solution (we’ll use Dynare - version 5.4 can be downloaded for free – coupled with Matlab). Given the short period of time, we will focus on one policy issue: a small open economy faced with a rise in the foreign interest rate. We’ll discuss the policy options for dealing with this, with a special focus on the role of sterilized intervention in the exchange rate market.

 

The course is aimed at a broad audience, including staff actively doing research with DSGE models, as well as staff interested in seeing what these models are about and what they are used for. No experience with Dynare will be assumed.

 

We will probably 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).

                                                                                                                                                                                  

 

 

Lectures

 

1)    Introduction and Overview (annotated presentation).

2)   Simple Closed Economy Model (annotated). Dynare exercise (annotated).

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

·      Basic structure of the model.

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

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

·      Introducing new equations into the model.

·      Properties: already starts to deviate from Mundell-Fleming.

5)   Introducing (Bernanke-Gertler-Gilchrist) Financial Frictions

·      Bernanke-Gertler-Gilchrist costly state verification into the model (closed economy version: CMR, JMCB 2003, AER 2014).

·      Balance sheet effects can have a major impact on model properties when some borrowing is in dollars.

6)   Sterilized Interventions.

·      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?

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

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

·      Adding sticky-in-dollars export prices (see Gopinath et al.).

 

 

 

 

 

Readings

 

General Background:

           

Adrian, Tobias, and others, 2022, “Managing Monetary Tradeoffs in Vulnerable Open Economies,” manuscript, International Monetary Fund.

Managing Monetary Tradeoffs in Vulnerable Open Economies

Gabaix and Maggiori, International Liquidity and Exchange Rate Dynamics, QJE, 2015.

Gopinath, Boz, Casas, Diez, Gourinchas and Plagborg-Moller, Dominant Currency Paradigm, AER, 2020.

Itskhoki and Mukhin, Optimal Exchange Rate Policy, manuscript, 2022.

Miranda-Agrippino and Rey, U.S. Monetary Policy and the Global Financial Cycle, 2020, RESTUD.

 

 

Closed Economy DSGE Models:

 

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

http://dm-edms.imf.org/cyberdocs/7085512&lib=DMSDR1S

 

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

 

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.).

http://dm-edms.imf.org/cyberdocs/DMSDR1s&doc=6011257

 

 

Open Economy DSGE Models:

 

Camara, Santiago, Lawrence J. Christiano, and Hüsnü Dalgic, 2023, “Sterilized FX Interventions: Benefits and Risks,” Working Paper.

 

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

 

Castillo and Medina, 2021, “Foreign Exchange Intervention and the Global Financial Cycle in Emerging Economies”, manuscript, Central Bank of Peru.