An Estimated Baseline Model of the Czech Open Economy

1. An Estimated Baseline Modelof 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 • NewKeynesian 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.