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AN ESTIMATED NEW KEYNESIAN POLICY MODEL FOR THE CZECH REPUBLICPowerPoint Presentation

AN ESTIMATED NEW KEYNESIAN POLICY MODEL FOR THE CZECH REPUBLIC

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### AN ESTIMATED NEW KEYNESIAN POLICY MODEL FOR THE CZECH REPUBLIC

Aleš Melecký

Department of Economics

Technical University of Ostrava

Outline of the Presentation REPUBLIC

- Motivation
- Model
- Data and Estimation Method
- Estimation Results
- Preview
- Impulse Response Analysis
- From inflation to exchange rate targeting

- Conclusions

Motivation REPUBLIC

- Regional monetary integrations, including the Czech Republic’s integration into EMU
- From IT to ERT
- Description of Czech economy and identification of shocks
- Identification of transmision channels

The employed model’s features REPUBLIC

- Two blocks:
- a small open economy (the Czech Republic)
- the rest of the world (euro area economy)

- New Keynesian policy model with rational expectations
- Relaxed cross-equation coefficient restrictions
- Empirically determined lag structure of the transmission mechanism

Model Equations – Domestic Block REPUBLIC

- Phillips curve – inflation dynamics
- IS curve – output gap dynamics
- MP reaction function – interest rate dynamics
- UIP equation – exchange rate dynamics

Model Equations – Foreign Block REPUBLIC

Data REPUBLIC

- Quarterly data series
- 1995Q1 to 2007Q4 for the Czech Republic
- 1981Q1 to 2007Q4 for the euro area

- Data Sources
- Datastream, Czech National Bank statistics, Fagan et al. (2001)(extrapolation back to 1981 for the euro area using growth rates)

Data REPUBLIC

- Output gap
- Deviation of the log GDP from its trend, estimated by the HP-filter and multiplied by 100

- Inflation
- Annualized percentage changes in CPI for the Czech Republic and harmonized CPI for the euro area

- Interest rate
- Three-month PRIBOR for the Czech Republic
- Three-month EURIBOR for the euro area

- Real exchange rate CZK/EUR
- Cross exchange rate using synthetic USD/EUR rate and CZK/USD rate, times CPIs ratio, in logs, linearly detrended, and multiplied by 100

Estimation method REPUBLIC

- Choose GMM over MLE-based methods to ensure higher robustness of estimates against possible misspecification
- Up to three lags of variables in the system used as instruments
- HAC estimated using the Bartlett kernel with the variable Newey-West bandwidth selection
- Pre-whitening of moment conditions applied
- BIC used for lag-length selection

Estimation Results REPUBLIC

Estimation Results – REPUBLICPhillips curve

- Inflation process more forward- than backward-looking both in CR and EA
- Sensitivity of inflation to demand pressures, almost three times higher in CR than EA
- Significant estimate of implies that Czech firms incorporate expected changes in excess demand into current prices (1% for 10%)
- ER pass-through – a 10 % increase in CZK/EUR expected to result in a 1.2 % increase in Czech inflation
- CR is estimated to face more than three times larger supply shocks than EA
- Data fit lower for CR (adj.R2 0.25) than for EA (adj.R2 0.83) -- less observations and the transition in CR

Estimation Results – REPUBLIC IS curve

- Output gap rigidity apparent in both countries (rho_y<0)
- Real interest rate elasticity fairly similar in CR and EA
- Interest rate transmission channel about two-times longer in EA than CR (6 vs. 3 periods)
- Exchange rate transmission channel (2-period lag) faster than IR transmission channel in CR
- Exchange rateelasticity estimated to be smaller than interest rate elasticity
- a 10 % increase in EA demand estimated to result in a 4 % increase in Czech output
- Data fit of OE-IS curve for CR (adj.R2 0.89) slightly better than CE-IS curve for EA (adj.R2 0.83)
- IS shocks’ size appears to be marginally higher in CR than EA

Estimation Results – MP rule REPUBLIC

- CNB and ECB smooth their interest rates, where ECB policy rate shows slightly more inertia
- ECB reactionto expected inflation appears to be higher than that of CNB
- ECB appears to place less weigh on output gap in its reaction function than CNB
- ECB – a more conservative central banker than CNB
- MP shocks in CR more than four times larger than in EA, i.e. ECB applies significantly less discretion than CNB
- Both MP reaction functions fit data well adj.R2 for CR 0.84 and for EA 0.98

Estimation Results REPUBLIC - UIP

- The estimated UIP equation implies that the standard deviation of the exchange rate shock is 5.86
- ER shock is thus the largest shock in the system
- Also, estimated to be significantly positively correlated over time

Impulse Response REPUBLICAnalysis

- How domestic (Czech) economic variables respond to individual structural shocks, both domestic and external
- The estimated system of equations with rational expectations solved into an VAR form using QZ algorithm of Sims (2002)
- The reduced-formused to generate impulse responses of domestic variables to selected shocks

Impulse Response REPUBLICAnalysis

- Domestic IS shock hits the Czech economy
- IS shock »↑output gap » ↑inflation » CNB reacts and ↑interest rate » ↑interest rate differential between CR and EA » CZK appreciates against EUR » the IR hike and CZK appreciation bring the output gap and inflation back to their steady-states

Impulse Response REPUBLICAnalysis

- Domestic AS shock hits the Czech economy
- AS shock » ↑inflation » CNB ↑interest rate » CZK appreciates against EUR » ↓output gap into negative values »IR and output gap return to steady states, CZK depreciates against EUR and settles around its steady state

Impulse Response REPUBLICAnalysis

- Domestic MP shock hits the Czech economy
- MP shock » CNB ↑interest rate » ↓ inflation » ↑ real interest rate differential between CR and EA » CZK strongly appreciates against EUR »output gap contracts significantly as a result of lower external price competitiveness

Impulse Response REPUBLICAnalysis

- Foreign IS shock hits the Czech economy
- Foreign IS shock » ↑foreign demand » ↑Czech output gap» ↑inflation &↑EAinflation » CNB & ECB ↑interest rate »positive real IR differential for CZK» CZK appreciates»inflation ↓ faster in CR» real IR peaks sooner »higher IR in EA»EUR appreciates against CZK before settling at its steadystate

Impulse Response REPUBLICAnalysis

- Foreign AS shock hits the Czech economy
- Foreign AS shock » ECB ↑interest rate » ↑real interest rate » CZKdepreciates against EUR » ↑ Czech net exports and output gap » ↑Czech inflation » CNB ↑interest rate » ↓real interest rate differential » CZK depreciation slows down » different intensity of CNB &ECB reactions and lengths of the monetary transmission » swings of the Czech variables before reaching steady states

Impulse Response REPUBLICAnalysis

- Foreign MP shock hits the Czech economy
- Foreign MP shock » ↑ EA real interest rate »depreciation of CZK against EUR » ↑net exports » Czech output gap positive » ↑ inflation » Czech output gap peaks & quickly returns to steady state » rapid adjustment causes a period of deflation » CNB ↓ interest rate » inflation returns back to its steady state

Impulse Response REPUBLICAnalysis

- Exchange rate shock hits the Czech economy
- Exchange rate shock » short CZK appreciation against EUR » negative Czech output gap & ↓ inflation » Czech output gap expected to adjust back fast » positive output gap adjustment » short-lived ↑ inflation » initially CNB ↑ interest rate » after several quarters CNB ↓interest rate to smooth out ER response which returns to zero in about 13 quarters

From REPUBLICinflation to exchange rate targeting

- Estimating CB´s loss function
- Optimalization of inflation targeting and movement to exchange rate targeting
- More in our article: From Inflation to Exchange Rate Targeting: Estimating the Stabilization Effects for a Small Open Economy(Ales Melecky and Martin Melecky)

Conclusions REPUBLIC

Model Estimation

- Pricing of firms in the Czech Republic shows higher rigidity than pricing of firms in EA
- ECB appears to be a more conservative central banker with higher MP rate inertia compared with the CNB
- The interest rate transmission channel of MP is significantly shorter in CR than EA
- A foreign demand shock has the highest impact on the Czech economy, higher than an ER shock or any domestic shock
- Out of the domestic shocks, the supply shock appears to be the most influential

Thank you! REPUBLIC

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