Reaction Functions in a Small Open Economy: What Role for Non-traded Inflation?
Abstract: I develop a structural general equilibrium model and estimate it for New Zealand using Bayesian techniques. The estimated model considers a monetary policy regime where the central bank targets overall inflation but is also concerned about output, exchange rate movements, and interest rate smoothing. Taking the posterior mean of the estimated parameters as representing the characteristics of the New Zealand economy, I compare the consequences that two alternative reaction functions have on the central bank's loss, for different specifications of its preferences. I obtain conditions under which the monetary authority should respond directly to non-tradable inflation instead of overall inflation. In particular, if preferences are relatively biased towards inflation stabilization, responding directly to overall inflation results in better macroeconomic outcomes. If instead the central bank places relatively more weight on output stabilization, responding directly to non-traded inflation is a better strategy.
"Reaction Functions in a Small Open ..." refers background in this paper
...Recent empirical analysis of aggregate data has obtained substantial evidence of habit persistence.7 Ct is a consumption index consisting of differentiated goods and Nt is total labour 7The idea of habit formation dates back to Duesenberry (1949)....
"Reaction Functions in a Small Open ..." refers methods in this paper
...In a second step, the model is written in state space form by adding a measurement 12For a detailed explanation, see Smets and Wouters (2003) and Smets and Wouters (2002)....
...Following the procedure used in Smets and Wouters (2003), I validate the model by comparing the model-based variances and crosscovariances with those in the data....