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Essays on small open economy macroeconomics

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    This thesis consists of an introductory chapter and three essays, all of which aim to study the functioning of a small open economy. The thesis starts with an investigation of export and import price determination and moves to a small open economy DSGE model framework in order to study the role of financial factors in economic fluctuations. In all three essays, theoretical small open economy models are used for quantitative analysis of the small open economy of Finland. The first essay develops a model for aggregate trade price inflation that takes into account two price setting conventions: local currency pricing (LCP) and producer currency pricing (PCP). In our empirical work, we confront our model with Finnish data and estimate the relative shares of LCP and PCP firms in the economy. In the estimation period 1980–1998, the share of local currency pricing was 40 percent in the export sector and 60 percent in the import sector, implying a limited pass-through from exchange rate to destination-country prices in both sectors. The second essay builds a small open economy DSGE model with the BGG financial accelerator and financial market shocks. In our empirical work covering the period 1995–2008, we provide evidence of an operative financial accelerator in Finland. The financial accelerator acts as an amplifying mechanism for many disturbances hitting the Finnish economy. Our main result is that financial market disturbances have contributed significantly to Finnish cyclical fluctuations between 1995 and 2008. Even allowing for several shocks stemming from both domestic sources and the international economy, domestic financial market shocks emerge as key drivers of recent business cycle fluctuations in Finland. The third essay studies the boom-bust period in Finland in the late 1980s and early 1990s, focusing on the role of financial factors and investment behaviour. We construct a small open economy DSGE model with the BGG financial accelerator and an unconventional shock structure that captures the key events of the episode. In this model framework, we study the role of financial market deregulation in the boom, the negative impact of the collapse of Soviet-Finnish trade in 1991, and the effect of the collapse of the fixed exchange rate regime in 1992. We argue that the financial accelerator mechanism is a key amplifying mechanism that helps the model to match, in particular, the large and persistent swings of investment first above and later below its trend. This essay demonstrates that the shocks Finland encountered combined with financial frictions are able to produce a boom and a severe depression, matching key salient features of the actual boom-bust cycle experienced in Finland in the late 1980s and early 1990s.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/erillisjulkaisut/Documents/E_43.pdf
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    Paper provided by Bank of Finland in its series Scientific Monographs with number E:43/2012.

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    Length: 177 pages
    Date of creation: 12 Mar 2012
    Date of revision:
    Handle: RePEc:hhs:bofism:2012_043
    Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/

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    1. Mark Gertler & Simon Gilchrist & Fabio Natalucci, 2001. "External constraints on monetary policy and the financial accelerator," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    2. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
    3. Yuriy Gorodnichenko & Enrique G. Mendoza & Linda L. Tesar, 2012. "The Finnish Great Depression: From Russia with Love," American Economic Review, American Economic Association, vol. 102(4), pages 1619-44, June.
    4. Marianne Baxter & Dorsey Farr, 2001. "Variable Factor Utilization and International Business Cycles," NBER Working Papers 8392, National Bureau of Economic Research, Inc.
    5. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
    6. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
    7. Ian Christensen & Ali Dib, 2008. "The Financial Accelerator in an Estimated New Keynesian Model," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(1), pages 155-178, January.
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