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Evaluating An Estimated New Keynesian Small Open Economy Model

  • Adolfson, Malin

    ()

    (Research Department, Central Bank of Sweden)

  • Laséen, Stefan

    ()

    (Monetary Policy Department, Central Bank of Sweden)

  • Lindé, Jesper

    ()

    (Research Department, Central Bank of Sweden)

  • Villani, Mattias

    (Research Department, Central Bank of Sweden)

This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003) using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank’s instrument rule. A key equation in the model - the uncovered interest rate parity (UIP) condition - is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence and volatility in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.

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Paper provided by Sveriges Riksbank (Central Bank of Sweden) in its series Working Paper Series with number 203.

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Length: 59 pages
Date of creation: 01 Feb 2007
Date of revision:
Handle: RePEc:hhs:rbnkwp:0203
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Sveriges Riksbank, SE-103 37 Stockholm, Sweden

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