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Parameter instabilities and monetary policy in a small open economy: Evidence from an estimated model for the UK

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  • Zamarripa, Rene

Abstract

This paper reconsiders whether monetary policy in small open economies responds to exchange rates by studying possible parameter instabilities in a Dynamic Stochastic General Equilibrium model. The main focus of the paper is to revisit preceding evidence on the response to exchange rate movements by the Bank of England and determine if its reaction function has remained constant throughout the sample. To this end, I estimate a small open economy general equilibrium model using Bayesian econometric techniques over rolling windows. I find overwhelming evidence of shifts in several parameters, including those related to the policy rule. Furthermore, posterior odds tests reveal a time-varying response to exchange-rate fluctuations by the monetary authorities. The results favor the model with the nominal exchange rate embedded in the policy rule for the initial subsamples. However, the evidence steadily evolves across windows and ultimately changes to prefer the model specification with no exchange rate. The paper also documents evident variations in the model dynamics derived from the instability of parameters via rolling-window impulse response functions and variance decomposition analysis.

Suggested Citation

  • Zamarripa, Rene, 2024. "Parameter instabilities and monetary policy in a small open economy: Evidence from an estimated model for the UK," International Review of Economics & Finance, Elsevier, vol. 96(PB).
  • Handle: RePEc:eee:reveco:v:96:y:2024:i:pb:s1059056024006178
    DOI: 10.1016/j.iref.2024.103625
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    More about this item

    Keywords

    Small open economy; Monetary policy; Bayesian methods; DSGE models; Time-varying parameters; Exchange rate;
    All these keywords.

    JEL classification:

    • E1 - Macroeconomics and Monetary Economics - - General Aggregative Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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