Monetary Policy in a Small Open Economy DSGE Model

By Lawrence J.
Christiano

**Overview**

This
course further develops tools developed in earlier meetings, to produce a model
that is suitable for estimation using Philippine data. The model can be used to
think about inflation targeting, foreign exchange management and fiscal tax
rules. The model has some of the frictions that factor into discussions of
exchange rate management. One is the fact that depreciation shocks may damage
the balance sheets of domestic firms; another is that sometimes it is hard to
know whether a shock to the exchange rate is temporary (thus, easy to smooth
out using exchange rate intervention) or permanent (thus, maybe impossible to
smooth without an unacceptable loss of reserves). The impact on policy of other
factors, maybe export prices are sticky in foreign currency or there is limited
substitutability between domestic and foreign inputs, will be considered. Some
material from previous meetings will be reviewed, such as the structure of the
simplest version of the small open-economy model, as well as elements of
Bayesian estimation and model solving. The Dynare code for all versions of the
models will be provided.

**Lectures**

1)
Estimation, with
application to open economy model (annotated lecture).

a)
Simple
exercise to understand:

i)
The
likelihood principle (which motivates maximum likelihood as an estimator) using
the probability theory at the start of the handout.

ii)
The Monte Carlo strategy for computing integrals discussed in the
slides.

b)
Example of
Bayesian posteriors (US monetary base, US base growth and
inflation).

c)
Very simple estimation example in
Dynare (the latter code includes MCMC.m, which you
can use to investigate how well the MCMC algorithm works when the distribution
being approximated is Weibull or a mixture of Normals.
Also, you can work through questions 2-10 in Assignment9.pdf, to get a feel for
Bayesian inference and other time series issues).

2)
Simple
Closed Economy Model.

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

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

3)
A simple version of the open economy model (annotated slides#1).

a) Basic structure of the model.

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

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

a) Introducing new equations into the model.

b) Properties: model deviates substantially
from Mundell-Fleming.

5)
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.

6)
Sterilized
Interventions and Dominant Currency Pricing

a) Introducing Dominant Currency Pricing into
the model (reference).

b) Sterilized Intervention.

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 Revie**w**, *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) Gabriel Rodriguez, Paul Castillo, and Harumi Hasegawa, “Does
the Central Bank of Peru Respond to Exchange Rate Movements? A Bayesian
Estimation of a New Keynesian DSGE Model with FX Interventions,” PUCP working paper.

9) (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:**** **

10)
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).

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