# Reaction Functions in a Small Open Economy: What Role for Non-traded Inflation?

TL;DR: The authors developed a structural general equilibrium model and estimated it for New Zealand using Bayesian techniques, considering a monetary policy regime where the central bank targets overall inflation but is also concerned about output, exchange rate movements, and interest rate smoothing.

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.

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Banque de France

^{1}TL;DR: In this article, the authors investigated the sources of current account imbalances accumulated within the European Monetary Union before the Great Recession and found that anticipated reductions in international borrowing costs can explain the observed evidence while productivity increases cannot: falling borrowing costs implies appreciation while increasing productivity implies depreciation.

Abstract: This paper investigates the sources of current account imbalances accumulated within the European Monetary Union before the Great Recession. First, it documents that starting in 1996, before the actual introduction of the euro, countries in the euro area periphery experienced increasing current account deficits, appreciating real exchange rates and output growing faster than trends. Then, it develops and estimates a small open economy DSGE model which encompasses a variety of possible unanticipated and anticipated shocks. The main finding is that anticipated reductions in international borrowing costs can explain the observed evidence while productivity increases (anticipated or not) cannot: falling borrowing costs implies appreciation while increasing productivity implies depreciation. Quantitatively, anticipated shocks account for one third of output, half of real exchange rate and two third of current account fluctuations. In particular, anticipated fluctuations in international borrowing costs explain respectively 30 and 40 percent of current account and real exchange rate movements.

37 citations

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TL;DR: In this paper, the authors evaluate the performance of an open economy DSGE-VAR model for New Zealand along both forecasting and policy dimensions, and show that the optimal policies react aggressively to inflation and contain a large degree of interest rate smoothing, but place a low weight on responding to output or the change in the nominal exchange rate.

Abstract: We evaluate the performance of an open economy DSGE-VAR model for New Zealand along both forecasting and policy dimensions. We show that forecasts from a DSGE-VAR and a 'vanilla' DSGE model are competitive with, and in some dimensions superior to, the Reserve Bank of New Zealand's official forecasts. We also use the estimated DSGE-VAR structure to identify optimal policy rules that are consistent with the Reserve Bank's Policy Targets Agreement. Optimal policy rules under parameter uncertainty prove to be relatively similar to the certainty case. The optimal policies react aggressively to inflation and contain a large degree of interest rate smoothing, but place a low weight on responding to output or the change in the nominal exchange rate.

36 citations

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TL;DR: In this article, a DSGE-VAR model with a Minnesota prior was proposed to compare with the Reserve Bank of New Zealand's published, judgmentally-adjusted forecasts of inflation.

31 citations

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TL;DR: In this article, the authors describe a simple extension of the Monacelli (2005) small open economy model that incorporates a non-tradable good, habit persistence and price indexation.

29 citations

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TL;DR: In this paper, the authors employ a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to evaluate the optimal monetary policy responses to commodity terms of trade shocks in commodity dependent emerging market economies.

26 citations

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TL;DR: The Almost Ideal Demand System (AIDS) as mentioned in this paper is a first-order approximation of the Rotterdam and translog models, which has been used to test the homogeneity and symmetry restrictions of demand analysis.

Abstract: Ever since Richard Stone (1954) first estimated a system of demand equations derived explicitly from consumer theory, there has been a continuing search for alternative specifications and functional forms. Many models have been proposed, but perhaps the most important in current use, apart from the original linear expenditure system, are the Rotterdam model (see Henri Theil, 1965, 1976; Anton Barten) and the translog model (see Laurits Christensen, Dale Jorgenson, and Lawrence Lau; Jorgenson and Lau). Both of these models have been extensively estimated and have, in addition, been used to test the homogeneity and symmetry restrictions of demand theory. In this paper, we propose and estimate a new model which is of comparable generality to the Rotterdam and translog models but which has considerable advantages over both. Our model, which we call the Almost Ideal Demand System (AIDS), gives an arbitrary first-order approximation to any demand system; it satisfies the axioms of choice exactly; it aggregates perfectly over consumers without invoking parallel linear Engel curves; it has a functional form which is consistent with known household-budget data; it is simple to estimate, largely avoiding the need for non-linear estimation; and it can be used to test the restrictions of homogeneity and symmetry through linear restrictions on fixed parameters. Although many of these desirable properties are possessed by one or other of the Rotterdam or translog models, neither possesses all of them simultaneously. In Section I of the paper, we discuss the theoretical specification of the AIDS and justify the claims in the previous paragraph. In Section II, the model is estimated on postwar British data and we use our results to test the homogeneity and symmetry restrictions. Our results are consistent with earlier findings in that both sets of restrictions are decisively rejected. We also find that imposition of homogeneity generates positive serial correlation in the errors of those equations which reject the restrictions most strongly; this suggests that the now standard rejection of homogeneity in demand analysis may be due to insufficient attention to the dynamic aspects of consumer behavior. Finally, in Section III, we offer a summary and conclusions. We believe that the results of this paper suggest that the AIDS is to be recommended as a vehicle for testing, extending, and improving conventional demand analysis. This does not imply that the system, particularly in its simple static form, is to be regarded as a fully satisfactory explanation of consumers' behavior. Indeed, by proposing a demand system which is superior to its predecessors, we hope to be able to reveal more clearly the problems and potential solutions associated with the usual approach.

4,620 citations

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01 Jan 19492,738 citations

### "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)....

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01 Oct 2002

TL;DR: In this article, a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area was developed and estimated with Bayesian techniques using seven key macroeconomic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate.

Abstract: This paper develops and estimates a dynamic stochastic general equilibrium (DSGE) model with sticky prices and wages for the euro area. The model incorporates various other features such as habit formation, costs of adjustment in capital accumulation and variable capacity utilisation. It is estimated with Bayesian techniques using seven key macro-economic variables: GDP, consumption, investment, prices, real wages, employment and the nominal interest rate. The introduction of ten orthogonal structural shocks (including productivity, labour supply, investment, preference, cost-push and monetary policy shocks) allows for an empirical investigation of the effects of such shocks and of their contribution to business cycle fluctuations in the euro area. Using the estimated model, the paper also analyses the output (real interest rate) gap, defined as the difference between the actual and model-based potential output (real interest rate).

2,716 citations

### "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)....

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...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....

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TL;DR: In this paper, the authors developed and estimated a structural model of inflation that allows for a fraction of firms that use a backward looking rule to set prices, and they concluded that the New Keynesian Phillips curve provides a good first approximation to the dynamics of inflation.

Abstract: We develop and estimate a structural model of inflation that allows for a fraction of firms that use a backward looking rule to set prices. The model nests the purely forward looking New Keynesian Phillips curve as a particular case. We use measures of marginal cost as the relevant determinant of inflation, as the theory suggests, instead of an ad-hoc output gap. Real marginal costs are a significant and quantitatively important determinant of inflation. Backward looking price setting, while statistically significant, is not quantitatively important. Thus, we conclude that the New Keynesian Phillips curve provides a good first approximation to the dynamics of inflation.

2,644 citations

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TL;DR: In this paper, the authors developed and estimated a structural model of inflation that allows for a fraction of firms that use a backward-looking rule to set prices, and the model nests the purely forward-looking New Keynesian Phillips curve as a particular case.

2,514 citations