An Estimated Baseline Model of the Czech Open Economy Karel Musil CNB, MU Econometric Day 28th November 2008

2 Basic Aim explore dynamic behavior of the Czech economy and monetary policy implications with using of Dynamic Stochastic General Equilibrium model New Keynesian DSGE approach microec. foundations, optimizing behavior, rigidities, … New Open Economy Macroeconomics Czech economy Inflation targeting

3 Adjusted Two-Country Model (A2C) DSGE model of two economies 4 representative agents Original 2C model: Lubik, Schorfheide (2005) adjusted  preferences and technologies  size of modeled economies extended  tradable (TR) and non-tradable (NONTR) sectors  risk premium in UIP condition All parameters estimated (not calibrated)

4 A2C: Representative Household Maximization of utility function with respect to budget constraint First order conditions (FOC) intratemporal rate marginal of substitution between consumption and leisure Intertemporal Euler equation UIP condition with risk premium Rigidity in consumption Consumption bundle: 3 types of goods

5 A2C: Connection to Abroad Terms of trade Overall CPI inflation Law of one price gap Real exchange rate relative prices of tradable and non-tradable goods Balassa-Samuelson effect International financial market UIP condition international risk sharing condition

6 A2C: Representative Firms Monopolistic competition in TR and NONTR Production function with only labor and country specific technologies for TR and NONTR world long-run technological progress FOC for output decision marginal costs development for TR and NONTR sector FOC for price behavior price rigidity (Calvo) 3 NK Phillips Curves for domestic TR, NONTR, imports

7 A2C: Central Monetary Authority Taylor rule in inflation targeting regime Growth rule for output Modified Taylor rule change in nominal interest rate depends on  last period interest rate  deviation of inflation from inflation target  output gap  monetary policy shock

8 A2C: Market Clearing Condition Domestic output influenced by foreign output Equilibrium conditions NONTR sector TR sector: partly exported imported goods Domestic goods market equilibrium degree of openness of both economies share of non-tradable consumption relative prices of TR and NONTR, terms of trade

9 A2C: Foreign Economy Similar (or reversed) behavior of agents Differences only TR sector different size of foreign economy own technological shocks Agents households producers central bank Market clearing condition

10 A2C: System of Model Equations 43 equations and identities in 5 blocks domestic economy behavior connection between domestic and foreign economies foreign economy behavior identities for inflation and relative prices exogenous processes for development of domestic and foreign technologies 24 parameters for estimation 9 shocks

11 Solving and Estimation Linearized and stationarized system rewritten into Linear Rational Expectations form Transformed to state-space representation Bayesian approach using prior information Dynare and Iris

12 Data Czech economy and effective Euroarea Quarterly, from I. Q 1999 to II. Q 2008 Deviation of level from balanced level domestic and Euroarea real GDP domestic CPI (deviation from inflation target) level of prices in the domestic tradable sector level of imported prices non-annualized domestic nominal 3M interest rate nominal exchange rate CZK/EUR Euroarea CPI non-annualized nominal foreign 3M EONIA

13 Results: A2C Estimated Parameters degree of openness (share of imports to GDP) domestic economy 72% foreign economy 2% share of non-tradable consumption 52% relatively high persistence in consumption behavior almost unit elasticity in labor supply elasticity of substitution between domestic TR and NONTR 0.03 domestic TR and foreign TR (imports) 0.70 average duration of price contracts (in quarters) domestic TR 1.6, domestic NONTR 1.3, domestic imports 2.4 foreign TR 4.4, foreign imports 3.7

14 Results: A2C Estimated Parameters … continuing Modified Taylor rule domestic central bank foreign central bank persistence for specific country shock (and for both sectors in the domestic economy) 0.56 – 0.61 persistence for long-run world technology progress 0.61 relatively low standard deviation for monetary policy shock in domestic and foreign economy world technology progress

15 Results: Analysis of Behavior Domestic technology changes long-run effect on domestic output Influence on foreign output, but very small Monetary policy shock domestic: long-lasting impacts foreign: long-run destabilization of domestic economy Risk premium shock short lived impact World long-run technology changes only theoretical Rest shocks: common characteristics

16 Foreign Monetary Policy Shock IRFs

17 Conclusion NK DSGE model with NOEM approach A2C is tailored to the Czech condition Foreign sector is a “natural constraint“ Influence of domestic economy to abroad some synergic effects effect of a foreign sector “stabilizer“ Very small mutual interdependence Appropriate approximation of behavior of the Czech economy

18 Thanks for your attention.