The impacts of economic structures on the performance of simple policy rules in a small open economy

Siok Kun, Sek (2009): The impacts of economic structures on the performance of simple policy rules in a small open economy. Published in: VDM Verlag (2010)

Abstract

Applying a stochastic dynamic general equilibrium model, the performance of various simple rules is analyzed in a small open economy context. The aspects that are considered in the analysis include the degree of exchange rate pass-through, trade openness, the policy objective and the source and persistency of shocks. The main objective of this analysis is to investigate if the rule reacts to exchange rate performs better than the basic closed economy rule without exchange rate term. Comparison on the performances is also made between the consumer inflation targeting and domestic inflation targeting rules. The results show that adding the exchange rate term to the policy rule enhances improvement especially in the higher pass-through case. The superior rule is the hybrid rule that reacts to the exchange rate term. CPI inflation targeting rules outperform the domestic inflation targeting rules in term of welfare loss. However, more complicated domestic inflation targeting rules generate lower loss in term of relative loss. On the second part of this chapter, comparisons on the performances of different exchange rate regimes are made under different source and persistency of shocks. The floating (pegged) regime is favored under more prominent real (nominal) shocks. The results suggest that emerging countries that experience very large real shocks should float their exchange rate.

• Item Type: MPRA Paper
• Language: English
• Keywords: simple policy rule, exchange rate pass-through, open economy model
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; N - Economic History > N1 - Macroeconomics and Monetary Economics ; Industrial Structure ; Growth ; Fluctuations > N15 - Asia including Middle East; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents > H30 - General; N - Economic History > N2 - Financial Markets and Institutions > N25 - Asia including Middle East; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination

References

Adolfson,M., Laseen,S, Lindé,J. & Villani,M. 2005. Bayesian estimation of an open economy DSGE model with incomplete pass-through. Sveriges riksbank working paper series no. 179.

Adolfson,M., Lindé,J. & Villani,M. 2006. Forecasting performance of an open economy dynamic stochastic general equilibrium model. Working paper. Sveriges RiksBank.

Adolfson,M. 2001. Monetary policy and exchange rates-breakthrough of pass-through. The Economic Research Institute, University of Stockholm.

Adolfson,M. 2007. Incomplete exchange rate pass-through and simple monetary policy rules. Journal of International Money and Finance 26: 468-494.

Alfaro,L. 2002. Inflation, openness and exchange rate regimes. The quest for short-term commitment. Harvard Business school.

Altig,D. et al. 2002. Technology shocks and aggregate fluctuations. Manuscript, Sveriges RiksBank.

An,S. & Schorfheide,F. 2006. Bayesian analysis of DSGE models. Singapore Management University & University of Pennsylvania. CEPR & NBER.

Apel,M., Nessen,M., Söderström,U. & Vredin,A. 1999. Different ways of conducting inflation targeting – theory and practice. Quarterly review 4/1999.

Artis,M. & Ehrmann,M. 2006. The exchange rate – a shock absorber or source of shocks? A study of four open economies. Journal of International Money and Finance 25: 874-893.

Ball,L. 1998. Policy rules for open economies. NBER working paper series 6760.

Ball,L. 1999. Policy rules for open economies. In: Taylor,J.B (Ed.). Monetary policy rules. The University of Chicago Press: 127-156.

Ball,L. 2000. Policy rules and external shocks. NBER working paper series 7910.

Barsky,R.F., Thomas,J., Miles,S. K. & Matthew,D. S.1987.Preference Parameters and Behavioral Heterogeneity: An Experimental approach in the Health and Retirement Study. Quarterly Journal of Economics,112: 537-579.

Batini,N. & Haldane,A. 1998. Forward-looking rules for monetary policy. Bank of England.

Batini,N., Harrision,R. & Millard,S.P. 2001. Monetary policy rules for an open economy. Bank of England.

Benigno,P. 2001. Price stability with imperfect financial integration. New York University and CEPR.

Brainard,W. 1967. Uncertainty and the effectiveness of policy. American Economic Review, 57(2): 411-425.

Brischetto,A. & Voss,G. 1999. A structural vector autoregression model of monetary policy in Australia. Bank of Australia Research Discussion paper 1999-11.

Bussière,M & Peltonen,T. 2008. Exchange rate pass-through in the global economy: the role of emerging market economies. ECB working paper no. 951/October 2008.

Calvo,G.A. & Mishkin,F.S. 2003. The mirage of exchange rate regimes for emerging market countries. NBER working paper 9808.

Campa,J.M., Golberg,L.S. & González-Mínguez,J.M. 2005. Exchange rate pass-through to import prices in the Euro area. NBER working paper.

Campa,J.M. & Goldberg,L.S. 2002a. Exchange rate pass-through into import prices. NBER working paper.

Campa,J.M. & Goldberg,L.S. 2002b. Exchange rate pass-through into import prices: a macro or micro phenomenon? NBER working paper.

Campa,J.M. & González-Mínguez,J.M. 2002. Differences in exchange rate pass-through in Euro area. Universidad de Navarra.

Cavoli,T. and Rajan,R. 2003. Designing appropriate exchange rate regimes for East Asia: inflation targeting and monetary policy rules. University of Adelaide. Discussion paper no. 0309.

Choudhri,E.U. 2005. Monetary policy in a small emerging economy: exploring desirable interest rate rules. Carleton University.

Choudhri.E.U. & Hakura, D.S. 2006. Exchange rate pass-through to domestic prices: Does the inflationary environment matter? Journal of International Money and Finance 25: 614-639.

Chow,H.K. & Kim Y. 2003. A common currency peg in East Asia? Perspectives from Western Europe. Journal of Macroeconomics 25: 331-350.

Christiano,L.J., Eichenbaum,M. & Evans,C.L. 1998. Monetary policy shocks: what have we learned and to what end? NBER working paper 6400.

Christiano,L.J., Eichenbaum,M. & Evans,C.L. 2001. Nominal rigidities and the dynamics effects of a shock to monetary policy. Federal Reserve Bank of Cleveland. Working paper 01-07.

Clarida,R.H., Gali,J. & Gertler,M. 2001. Optimal monetary policy in closed versus open economies: An integrated approach. NBER no 8604.

Cook,D. & Devereux,M.B. 2006a. Accounting for the East Asian crisis: a quantitative model of capital outflows in small open economies. Journal of Money, Credit and Banking. Vol. 38 (3): 721-749.

Cook,D. & Deveruex,M.B. 2006b. External currency pricing and the East Asian crisis. Journal of International Economics 69: 37-63.

Corsetti,G. 2005. Openness and the case for flexible exchange rates. European University Institute. Working papers no. 2005/21.

Côté,D. & Lam, J. 2001. Simple rules in the M1-VECM. Bank of Canada.

Côté,D et. al. 2002. The performance and robustness of simple monetary policy rules in models of the Canadian economy. Manuscript, Bank of Canada.

Côté,D, Kuszczak,J, Lam,J.P, Liu,Y & St-Amant,P. 2002. The performance and robustness simple monetary policy rules in models of the Canadian economy. Bank of Canada. Technical report no. 92.

De Fiore,F. & Liu,Z. 2002. Openness and equilibrium determinacy under interest rate rules. European Central Bank. Working paper no. 173.

DeJong,D.N., Ingram,B.F. & Whiteman,C.H. 1997. A Bayesian approach to dynamic macroeconomics. Then University of Pittsburgh & The University of Iowa.

Dennis,R. 2000. Optimal simple targeting rules for small open economies. Federal Reserve Bank of San Francisco.

Dennis,R. 2001. Solving for optimal simple rules in rational expectations models. Federal Reserve Bank of San Francisco.

Dennis,R. 2003. New Keynesian optimal-policy models: an empirical assessment. Federal Reserve Bank of San Francisco.

Desroches,B. 2004. The transmission of world shocks to emerging market countries: an empirical analysis. Bank of Canada working paper 2004-44.

Devereux, M.B., Lane,P.R. & Xu,J. 2005. Exchange rate and monetary policy in emerging market economies. The Institute for International Integration Studies Discussion paper series.

Devereux,M.B. & Lane,P.R. 2003. Understanding bilateral exchange rate volatility. Journal of International Economics 60: 109-132.

Devereux,M.B. & Poon,D. 2004. A simple model of optimal monetary policy with financial constraints. The University of British Columbia.

Devereux,M.B., Lane, P.R. & Xu,J. 2006. Exchange rate and monetary policy in emerging market economies. The Economic Journal 116: 478-506.

Devereux M.B. & Yetman,J. 2009.Price adjustment and exchange rate pass-through. Journal of International Money and Finance xxx: 1-20.

Dobrynskaya,U. 2008. The monetary and exchange rate policy of the Central Bank of Russia under asymmetrical price rigidity. Journal of Innovations Economics. 1(1): 29-62.

Edwards,S. 2006. The relationship between exchange rates and inflation targeting revisited. NBER working paper series no. 12163.

Eichenbaum,M,S., Hansen,L.P. & Singleton,K.J. 1988. A Time series analysis of representative agent models of consumption and leisure choice under uncertainty. Quarterly Journal of Economics, 103, 51-78.

Elekdag,S., Justiniano,A. & Tchakarov,I. 2005. An estimated small open economy model of the financial accelerator. IMF working paper WP/05/44.

Flamini,A. 2005. Inflation targeting and exchange rate pass-through. Graduate Institute of International Studies. Working paper no. 04/2004.

Fraga,A. et al. 2003. Inflation targeting in emerging market economies. In: Getler, Mark & Keneth Rogoff, orgs. NBER Macroeconomics Annual 18. MIT Press: 365-400.

Frankel,J.A. & Rose,A.K. 1998. The endogeneity of the optimum currency area criteria. The Economic Journal 108: 1009-1025.

Fuhrer, J.C. 2000b. Habit Formation in consumption and its implications for monetary policy models. American Economic Review, 90, No. 3 :367–90.

Fuhrer,J.C. 1998. An optimizing model for monetary policy analysis: can habit formation help? Federal Reserve Bank of Boston.

Fuhrer,J.C. 2000a. Optimal monetary policy in a model with habit formation. Federal Reserve Bank of Boston.

Gagnon,J.E. & Ihrig,J. 2004. Monetary policy and exchange rate pass-through. Board of Governors of Federal Reserve System.

Gali,J. & Gertler,M. 1999. Inflation dynamics: a structural econometric analysis. Journal of Monetary Economics. 44: 195-222.

Gali,J. & Monacelli,T. 2005. Monetary policy and exchange rate volatility in a small open economy. The Review of Economic Studies: 72(3).

Garretsen,H., Moons.G. & Aarle,B. 2005. Monetary policy in the Euro area: an analysis using a stylized New Keynesian model. Utrecht University, University of Antwerp & University of Maastricht.

Gerlach,S. & Smets,F. 2000. MCIs and monetary policy. European Economic Review 44: 1677-1700.

Giannoni,M.P. & Woodford,M. 2003. Notes on model for ‘optimal inflation targeting rules’. Columbia University and Princeton University.

Giovanni,J. & Levchenko,A.A. 2008. Trade openness and volatility. IMF working paper WP/08/146.

Giuliodori,M. 2004. Nominal shocks and the current account: a structural VAR analysis of 14 OECD countries. Review of World Economics vol. 140(4): 569-592.

Goodhart,C. & Hofmann,B. 2005. The Phillips curve, the IS curve and monetary transmissionL evidence for the US and the Euro area. CESifo Economic Studies, vol. 51: 757-775.

Hall,R.E. 1988. Intertemporal substitution in consumption. The Journal of Political Economy. Vol. 96(2): 339-357.

Hausmann,R., Panizza,U. & Stein,E. 1999. Why do countries float the way they float? Journal of Development Economics 66: 387-414.

Ho,C. & McCauley,R.N. 2003. Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies. BIS working papers no. 130.

Hoffmaister,A.W. & Roldós,J.E. 1997. Are business cycles different in Asia and Latin America? IMF working paper WP/97/9.

Hoffmann,M. 2005. Fixed versus flexible exchange rate: evidence from developing countries. University of Cologne.

Ito,T., Sasaki,Y.N. & Sato,K. 2005. Pass-through of exchange rate changes and macroeconomic shocks to domestic inflation in East Asian countries. RIETI discussion paper series 05-E-020.

Jeanfils,P.2001. A guided tour of the world of rational expectations models and optimal policies. National Bank of Belgium.

Juillard,M. et. al. 2005. Welfare-based monetary rules in an estimated DSGE model of the US economy. CEPREMAP.

Juillard,M. et. al. 2006. Welfare-based monetary rules in an estimated DSGE model of the US economy. ECB working paper no. 613.

Justiniano,A. & Preston,B. 2004. Small open economy DSGE models: specification, estimation and model fit. IMF and Columbia University.

Kimura,T. & Kurozumi,T. 2002. Effectiveness of history-dependent monetary policy. Bank of Japan.

Kirsanova,T., Leith,C. & Wren-Lewis,S. 2006. Should central banks target consumer prices or the exchange rate? The Economic Journal, 116:F208-F231.

Kollman,R. 2004. Welfare effects of a Monetary Union: the role of trade openness. Journal of the European Economic Association. 2(2-3): 289-301.

Leitemo,K. & Söderström,U. 2004. Robust monetary policy in the New Keynesian framework. Discussion paper no. 4805. Centre for Economic Policy Research.

Leitemo,K. & Söderström,U. 2005. Simple monetary policy rules and exchange rate uncertainty. Journal of International Money and Finance 24: 481-507.

Levin,A., Wieland,V. & Williams,J.1998. Robustness of simple monetary policy rules under model uncertainty. National Bureau of Economic Research. Working paper 6570.

Lindé,J, Nessén,M. & Söderström,U. 2004. Monetary policy in an estimated open economy model with imperfect pass-through. Sveriges Riksbank. Working paper no. 167.

Lubik,T. & Schorfheide,F. 2005. A Bayesian look at New Open Economy Macroeconomics. Johns Hopkins University & University of Pennsylvania.

Maih,J. 2005. A symmetric trade and nominal rigidities in a DSGE perspective: implications for the transmission of shocks and real exchange rate dynamics. Dissertation for the PhD degree. University of Oslo.

Mayer,E. 2003. The mechanics of a reasonably fitted quarterly New Keynesian macro model. Universität Würzburg Economic papers. No.41.

Mayer,E. 2004. The mechanics of a reasonably fitted quarterly New Keynesian macro model. University of Würzburg.

Merola,R. 2006. A small open economy model with financial accelerator. Université Catholique de Louvain la neuve.

Minella,A. et. al. 2003. Inflation targeting in Brazil. Constructing credibility under exchange rate volatility. Journal of International Money and Finance. 22: 1015-1040.

Ministry of Economy, Trade and Industry. Trade structure underlying East Asian growth – advancement of triangular trade in: White paper on International Economy and trade 2005. METI.

Mishkin,F. S. 2000. Inflation targeting in emerging market countries. NBER working paper series no. 7618.

Moessner,R. 2005. Optimal discretionary policy and uncertainty about inflation persistence. European Central Bank. Working paper no. 540.

Mohamed,D. 2006. Hybrid inflation and price level targeting in small open economy. MRPA.

Mohanty,M.S. & Klau,M. 2004. Monetary policy rules in emerging market economies: issues and evidence. BIS working papers no. 149.

Mohanty,M.S. & Klau,M. 2005. Monetary policy rules in emerging market economies: Issues and evidence in: Monetary policy and macroeconomic stabilization in Latin America, eds. Rolf J. Langhammer and Lucio Vinhas de Souza. The Kiel Institute.

Monacelli,T. 2003. Moentary policy in a low pass-through environment. ECB working paper no. 227.

Nogueira Junior,R.P. 2007. Inflation targeting and the role of exchange rate pass-through. University of Kent.

Orphanides,A. 1998. Monetary policy evaluation with noisy information. Finance and Economics Discussion paper no 1998-50. Board of Governors of the Federal Reserve System.

Osawa,N. 2006. Monetary policy responses to the exchange rate: empirical evidence from three East Asian inflation-targeting countries. Bank of Japan working paper series no. 06-E-14.

Parrado,E. 2004. Inflation targeting and exchange rate rules in an open economy. IMF working paper WP/04/21.

Pytlarczyk,E. 2005. An estimated DSGE model for the German economy within the Euro area. Universitat Hamburg.

Ratto,M., Röger,W., Veld,J. & Girardi,R. 2005. An estimated new Keynesian dynamic stochastic general equilibrium model of the Euro area. European Economy. Economic paper no. 220. European Commission.

Rudebusch,G.D. & Svensson,L.E.O. 1998. Policy rules for inflation targeting, in Taylor,J (ed.), Monetary policy rules. University of Chicago Press. 203-253.

Ruge-Murcia,F.J. 2003. Methods to estimate dynamic stochastic general equilibrium models. Universite de Montreal.

Sack,B. & Wieland,V. 1999. Interest rate smoothing and optimal monetary policy: a review of recent empirical evidence. Board of Governors of the Federal Reserve System.

Schmidt-Hebbel,K. & Werner,A. 2002. Inflation targeting in Brazil, Chile and Mexico: performance, credibility and the exchange rate. Economia. 2(2): 31-89.

Senay,O. 2001. The role of the exchange rate in monetary policy rules. Middle East Technical University and University of York.

Smets,F. & Wouters,R. 2002a. Openness, imperfect exchange rate pass-through and monetary policy. NBB working paper no. 19.

Smets,F. & Wouters,R. 2002b. An estimated dynamic stochastic general equilibrium model of the Euro area. National Bank of Belgium working papers-research series.

Smets,F. & Wouters,R. 2004. Forecasting with a Bayesian DSGE model: an applications to the Euro area. National Bank of Belgium working papers-research series no. 60.

Söderlind,P. 1999. Solution and estimation of RE macromodel with optimal policy. European Economic Review 43: 813-823.

Söderlind,P. 2003. Lecture notes for monetary policy (PhD course at UNISG). University of St. Gallen and CEPR.

Söderström,U. 2000. Monetary policy with uncertain parameters. European Central Bank. Working paper no. 13.

Sun,W. & An,L. 2008. Asymmetric shocks and exchange rate regimes in East Asia. International Research Journal of Finance and Economics 22: 38-48.

Sutthasri,P. 2007. Parameter calibration for the Bank of Thailand DSGE model (in Thai). In: Tanboon,S. 2008. The Bank of Thailand structural model for policy analysis. Bank of Thailand.

Svensson,L.E.O & Woodford,M. 2000. Indicator variables for optimal policy. NBER working paper No. 7953.

Svensson,L.E.O. 1997. Inflation targeting: some extensions. NBER working paper No. 5962.

Svensson,L.E.O. 1998. Inflation targeting as a monetary policy rule. CEPR and NBER.

Svensson,L.E.O & Woodford,M. 2003. Implementing optimal policy through inflation forecast targeting. Princeton University.

Svensson,L.E.O. 2003. What is wrong with Taylor rules? Using judgment in monetary policy through targeting rules. Journal of Economic Literature 41: 426-477.

Svensson,L.E.O. 2007. Optimization under commitment and discretion, the recursive saddle point method, and targeting rules and instrument rules: Lecture notes. Princeton University.

Tanboon,S. 2007. Stylized facts of the Thai economy. In: Tanboon,S. 2008. The Bank of Thailand structural model for policy analysis. Bank of Thailand.

Tanboon,S. 2008. The Bank of Thailand structural model for policy analysis. Bank of Thailand.

Taylor,J.B. 1999. The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European Central Bank. Journal of Monetary Economics 43: 655-679.

Taylor,J.B. 2001. The role of the exchange rate in monetary policy rules. American Economic Review 91(2): 263-267.

Taylor,J.B. 2000. Low inflation, pass-through, and the pricing power of firms. European Economic Review. 44(7): 1389-1408.

Villani,M. & Warne,A. 2003. Monetary policy analysis in a small open economy using Bayesian cointegrated structural VARs. Sveriges Riksbank working paper series no. 156.

Wang,L. 2005. Degree of openness and the choice of exchange rate regimes – a re-evaluation with value-added based openness measures. Dissertation. Universität Hohenheim.

Welz,P. 2005. Quantitative New Keynesian macroeconomics and monetary policy. Uppsala Universitet.

Welz,P. 2006. Assessing predetermined expectations in the standard sticky-price model: a Bayesian approach. ECB working paper series no. 621.

Wohltmann,H-W. & Winkler,R. 2008. Anticipated and unanticipated oil price shocks and optimal monetary policy. Christian-Albrechts- Universität zu Kiel. Economic working paper no. 2008-05.

Wollmershäuser,T. 2006. Should central banks react to exchange rate movements? An analysis of the robustness of simple rules under exchange rate uncertainty. Journal of Macroeconomics 28: 493-519.

Woodford,M. 2001. The Taylor rule and optimal monetary policy. Princeton University.

Woodford,M. 2002. Optimal interest rate smoothing. Princeton University.