An Economy in Transition and DSGE: What the Czech National Bank’s New Projection Model Needs

Since the introduction of the inflation targeting regime in 1998 the Czech National Bank has made considerable progress in developing formal tools for supporting its Forecasting and Policy Analysis System. This paper documents the advances in the ongoing research aimed at developing a DSGE small open economy model designed to capture some of the most important features of the Czech economy - both the business-cycle regularities and the recent developments associated with the economy's transition and its convergence towards the industrialized European countries. The model in its current form is able to capture trends in relative prices, allow for medium-convergence in expenditure shares, and deal with the undercapitalization and investment inflow issues. Besides the model exhibits real and nominal rigidities that are in line with the recent New Open Economy Macroeconomics literature built fully on first principles. The innovative features of our model include the international currency pricing scheme permitting flexible calibration of import and export price elasticities along with the disconnect of the nominal exchange rate, the policy reaction function with a parameterized forecast horizon, and a generalized capital accumulation equation with imperfect intertemporal substitution of investment.