An estimated new keynesian policy model for the czech republic
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AN ESTIMATED NEW KEYNESIAN POLICY MODEL FOR THE CZECH REPUBLIC. Ale š Meleck ý Department of Economics Technical University of Ostrava. Outline of the Presentation. Motivation Model Data and Estimation Method Estimation Results Preview Impulse Response Analysis

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Presentation Transcript
An estimated new keynesian policy model for the czech republic


Aleš Melecký

Department of Economics

Technical University of Ostrava

Outline of the presentation
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
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
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


  • 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)


  • 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
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 phillips curve
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 is curve
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
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 uip
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 analysis
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 analysis1
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 analysis2
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 analysis3
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 analysis4
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 analysis5
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 analysis6
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 analysis7
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 inflation to exchange rate targeting
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