Monetary Policy in a Small Open Economy DSGE Model


By Lawrence J. Christiano




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.





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).

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.

6)     Sterilized Interventions and Dominant Currency Pricing

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

b)     Sterilized Intervention.





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)     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).