DSGE Modelling at Central Banks: Country Practices and How it is Used in Policy Making Haris Munandar Bank Indonesia SEACEN-CCBS/BOE-BSP Workshop on DSGE Modelling and Econometric Techniques Manila, 27 November 2009

1 BISMA: Bank Indonesia Structural MAcro model Implementation of a full-fledged Inflation Targeting Framework (ITF) on July 2005 necessitates support by a model with the following features:  capturing supply and demand side very well  more resistant to Lucas critique  incorporating rational expectation explicitly through optimization behaviour of economic agents  incorporating forward-looking endogenous interest rate reaction  ability to be utilized in policy simulation and forecasting

Role of economic models in Bank Indonesia 2

Outline Specification and model structure Behaviour of agents Market clearing conditions and identities Data and methodology Estimation, calibration and IRF Forecasting and simulation results 3

4 Micro-founded Macroeconomic model (DSGE). New Keynesian – Neoclassical Synthesis:  Long run neoclassical steady state (neutrality of money)  Short-run Keynesian dynamics  Rational expectation Nominal rigidities : price and wage staggered contract ala Rotemberg Real rigidities : habit formation in consumption, and adjustment cost in capital Interest rate reaction function (Taylor Rule) secara endogen dan forward looking sejalan dengan penerapan ITF Two core economic agents (households and firms) and 3 auxiliary economic agents (central bank, government and foreign/rest of the world), Specification

5 Model structure

Outline Specification and model structure Behaviour of agents Market clearing conditions and identities Data and methodology Estimation, calibration and IRF Forecasting and simulation results 6

7 Household  Own assets (domestic and foreign bond); purchase finished goods and investment goods; receive wages as return for labor supplied to firms; receive rental capital from firms; and receive profits from firm  Objective Function :  Budget Constraints:

8 Household Investment increase the capital stock over time according to Capital Accumulation eq : Wage Setting  The labor aggregator solve: where is the flexible-price optimal nominal wage and are in logs

9 Household: log-linear solution Consumption Flexible Wage Investment where Shadow Price of Capital

10 Household: log-linear solution Capital Supply Uncovered Interest Parity Wage Inflation where

11 Assumption : Monopolistically competitive firms with Cobb-Douglas Production Function : Profits Price Setting The price aggregator solve: where is the flexible-price and are in logarithmic Flexible price Domestic Intermediate Firm

12 Domestic intermediate firm: log-linear solution Output Labor demand Capital demand PPI inflation where

13 Consumption goods producer Profit Price setting The price aggregator solve: where is the flexible-price and are in log Flexible - consumption goods producer’s price: Consumption goods producer

14 Cons. goods producer: log-linear solution Consumption goods Domestic consumption intermediate demand Imported consumption intermediate demand CPI inflation where

15 Assumption Producing investment goods from imported materials Investment Goods Producer Profit Investment goods producer

16 Invest. goods producer: log-linear solution Investment goods Investment goods price

17 Assumption Producing government goods from domestic materials Government goods producer Profit Government goods producer Government goods producer: log-linear solution Government goods

18 Export goods producer Profit Price Setting The price aggregator solve: where is the flexible-price and are in log Flexible - export goods producer’s price: Export goods producer

19 Export goods producer: log-linear solution Export goods Domestic export intermediate demand Imported export intermediate demand Export price inflation where

20 Importers Provide imported materials as intermediate inputs to final good production Only act like merchants – no production function The price aggregator solve: where is the flexible-importer’s price and are in log Flexible - import’s price:

21 Importer: log-linear solution Imported Inflation where

22 Central bank Central bank objective function is to set the nominal short term interest rate i t in response to deviations of inflation from the target as well as output gap

23 Government Government fiscal authority  For simplification: government chooses the current government expenditure by smoothing previous government expenditure  However, it has to consider the source of financing from taxes, and bond issuance

24 Balance of payment Balance of Payment Balance of payment equation is the result of interactions among all agents, which has connection with foreign sectors

Outline Specification and model structure Behaviour of agents Market clearing conditions and identities Data and methodology Estimation, calibration and IRF Forecasting and simulation results 25

26 Export: Import: Dom. Intermediate Goods : Nominal GDP: Market clearing conditions and identities

27 Market clearing conditions and identities Risk Premium : Foreign Economy : Technology Growth

Outline Specification and model structure Behaviour of agents Market clearing conditions and identities Data and methodology Estimation, calibration and IRF Forecasting and simulation results 28

29 Data and methodologi Data  Kuartalan : 2000 Q1 – 2009 Q2 Solving Rational Expectation  Generalized Schur Decomposition (Klein, 2000) Estimation  Bayesian Robustness Check  Impulse Response Function (IRF)

Outline Specification and model structure Behaviour of agents Market clearing conditions and identities Data and methodology Estimation, calibration and IRF Forecasting and simulation results 30

Parameter estimation 31

Parameter calibration 32

IRF – unfavorable inflation shock 33

IRF – exchange rate depreciation shock 34

IRF – favorable foreign demand shock 35

IRF – tight policy 36

Outline Specification and model structure Behaviour of agents Market clearing conditions and identities Data and methodology Estimation, calibration and IRF Forecasting and simulation results 37

Simulation result: loose policy vs. baseline 38

Simulation result: loose policy vs. baseline 39

Simulation result: tight policy vs. baseline 40

Simulation result: tight policy vs. baseline 41

42 THANK YOU