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Modeling exchange rate, inflation, and interest rate in a small open economy. A data-based approach to estimating a New Keynesian model with rational expectations

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Abstract

Building on a New Keynesian rational expectations framework, we develop a structural empirical model that jointly determines the real exchange rate, inflation, and the nominal interest rate in a small open economy. Employing a full-information system design and estimation approach that avoids imposing unduly restrictive a priori parameter constraints, we identify a forward-looking Phillips curve while addressing simultaneity bias. Our empirical findings reveal persistent exchange rate dynamics that diverge from New Keynesian rational expectations but align with prior evidence, suggesting the presence of multiple equilibria.

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  • Roger Hammersland & Dag Kolsrud, 2025. "Modeling exchange rate, inflation, and interest rate in a small open economy. A data-based approach to estimating a New Keynesian model with rational expectations," Discussion Papers 1026, Statistics Norway, Research Department.
    • Handle: RePEc:ssb:dispap:1026
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    File URL: https://www.ssb.no/en/nasjonalregnskap-og-konjunkturer/nasjonalregnskap/artikler/modeling-exchange-rate-inflation-and-interest-rate-in-a-small-open-economy/_/attachment/inline/620cb897-4d33-45ff-9928-fbf387e973b8:7f33d1629cd3f63559eeeb454c386abddd34893d/DP1026.pdf
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    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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