An Estimated DSGE Model for Integrated Policy Analysis

IMF Working Papers, June 30, 2023

Source details

Authors: Kaili Chen, Marcin Kolasa, Jesper Lindé, Hou Wang, Pawel Zabczyk, Jianping Zhou
Published: June 30, 2023
Series: IMF Working Papers
DOI: https://doi.org/10.5089/9798400245763.001

Estimated a New Keynesian small open economy model that allows for foreign exchange (FX) market frictions and a potential role for foreign exchange interventions (FXI).
Sample covers a large set of emerging market economies (EMEs) and some inflation targeting (IT) advanced economy (AE) countries serving as a control group.
Estimation approach: Bayesian Estimation.
Key structural features preserved in the model: FX market frictions, incomplete financial markets, investors portfolio outflow dynamics, and an FXI rule governing interventions.

Whether interest rate policy alone may be insufficient to stabilize output and inflation following capital outflow shocks.
The extent to which FX interventions (FXI) can improve policy tradeoffs in response to volatile capital flows.
Comparative scenarios between EMEs and IT AEs to assess heterogeneity in transmission of capital outflow shocks.

Significant structural differences between AEs and EMEs—most notably in FX market depth—lead to different transmission of capital outflow shocks.
Differences in FX market depth justify occasional use of FXI in some EMEs in certain situations.
Accounting for the endogeneity of FXI behavior is critically important when assessing:
- FX market depth estimates.
- Policy tradeoffs associated with volatile capital flows in past episodes.
Results support the view that, under some conditions, interest rate policy may not be sufficient to stabilize output and inflation after capital outflow shocks, and that FXI can alter these tradeoffs.

Policymakers in EMEs should consider the structural characteristic of FX market depth when designing integrated policy responses to capital outflow shocks.
Occasional use of FXI can be justified in some EMEs, conditional on modelled transmission mechanisms and endogenous intervention behavior.
Analyses of past FX interventions and market depth must control for the endogeneity of FXI to avoid biased assessments of intervention effectiveness.

Subjects: Currency markets, Exchange rate adjustments, Exchange rates, Financial markets, Foreign exchange, Foreign exchange intervention, Inflation, Prices.
Keywords: Bayesian Estimation, Currency markets, Emerging Markets, Endogenous Risks, Exchange rate adjustments, Exchange rates, Foreign Exchange Intervention, FX market depth, FXI rule, FXIS impact transmission, Global, Incomplete Financial Markets, Inflation, Integrated Policy Framework, investors portfolio outflow, Monetary Policy, outflow shock.