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Reaction functions in a small open economy: What role for non-traded inflation?

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Abstract

I develop a structural general equilibrium model and estimate it for New Zealand using Bayesian techniques. The estimated model considers a monetary policy regime where the central bank targets overall inflation but is also concerned about output, exchange rate movements, and interest rate smoothing. Taking the posterior mean of the estimated parameters as representing the characteristics of the New Zealand economy, I compare the consequences that two alternative reaction functions have on the central bank's loss, for different specifications of its preferences. I obtain conditions under which the monetary authority should respond directly to non-tradable inflation instead of overall inflation. In particular, if preferences are relatively biased towards inflation stabilization, responding directly to overall inflation results in better macroeconomic outcomes. If instead the central bank places relatively more weight on output stabilization, responding directly to non-traded inflation is a better strategy.

Suggested Citation

  • Ana Maria Santacreu, 2005. "Reaction functions in a small open economy: What role for non-traded inflation?," Reserve Bank of New Zealand Discussion Paper Series DP2005/04, Reserve Bank of New Zealand.
  • Handle: RePEc:nzb:nzbdps:2005/04
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    Cited by:

    1. Anella Munro & Rishab Sethi, 2007. "Understanding the New Zealand current account: A structural approach," Reserve Bank of New Zealand Discussion Paper Series DP2007/10, Reserve Bank of New Zealand.
    2. Dupor, William D. & McCrory, Peter B., 2014. "A Cup Runneth Over: Fiscal Policy Spillovers from the 2009 Recovery Act," Working Papers 2014-29, Federal Reserve Bank of St. Louis, revised 01 Apr 2016.
    3. Lees, Kirdan & Matheson, Troy & Smith, Christie, 2011. "Open economy forecasting with a DSGE-VAR: Head to head with the RBNZ published forecasts," International Journal of Forecasting, Elsevier, vol. 27(2), pages 512-528, April.
    4. Hove, Seedwell & Touna Mama, Albert & Tchana Tchana, Fulbert, 2015. "Monetary policy and commodity terms of trade shocks in emerging market economies," Economic Modelling, Elsevier, vol. 49(C), pages 53-71.
    5. Matheson, Troy, 2010. "Assessing the fit of small open economy DSGEs," Journal of Macroeconomics, Elsevier, vol. 32(3), pages 906-920, September.
    6. Lahcen, Mohammed Ait, 2014. "DSGE models for developing economies: an application to Morocco," MPRA Paper 63404, University Library of Munich, Germany.
    7. Thomas Lubik, 2006. "A simple, structural, and empirical model of the antipodean transmission mechanism," New Zealand Economic Papers, Taylor & Francis Journals, vol. 40(2), pages 91-126.
    8. Kirdan Lees & Troy Matheson & Christie Smith, 2007. "Open Economy Dsge-Var Forecasting And Policy Analysis: Head To Head With The Rbnz Published Forecasts," CAMA Working Papers 2007-05, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    9. Peter McCrory & Bill Dupor, 2015. "Fiscal Policy Spillovers: Points of Employment to Places of Residence," 2015 Meeting Papers 47, Society for Economic Dynamics.
    10. SENBETA, Sisay Regassa, 2011. "A small open economy new Keynesian DSGE model for a foreign exchange constrained economy," Working Papers 2011004, University of Antwerp, Faculty of Applied Economics.

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    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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