Model for Analysis and Simulations: A Small Open Economy DSGE for Chile

Juan Pablo Medina Central Bank of Chile Claudio Soto Central Bank of Chile

Work in Progress Central Bank Workshop on Macroeconomic Modelling 2006

Motivation Need for an alternative tool for analysis and forecasting at the CBC New Keynesian paradigm (NKM) provide a valuable tool for policy analysis Central Banks have developed large-scale open and multi-country models based on the NKM approach: GEM, SIGMA, models at Riksbank, BoE (BEQM), BoC (TOTEM) MAS Model Advances in Bayesian estimation techniques make it feasible to estimate mediumscale NKM models

This presentation Current version of the MAS Empirical assessment: Bayesian Estimation of key parameters Impulse-Response function Historical decomposition of Chilean business cycles Challenges for taking it to the policy environment

Main Conclusions Empirical relevance of nominal and real rigidities in the Chilean economy Monetary policy transmission: max impact on yearly ination is at 4th quarter (response of exchange rate relevant for this result) External conditions have played an important role to explain RER and ination developments, but External conditions have had a minor role in explaining GDP behavior compared to domestic conditions (technology and demand) Several Challenges: Validation of the transmission mechanisms identied in the model Characterization of monetary policy Trends, regime changes and how to obtain the cyclical information of variables

Models Description Closely related to CEE (2005), Altig et al (2004), Smets and Wouters (2003) Small open economy with endogenous risk premium Households, Firms, Government and foreign block Sectors: Home goods and commodity exported goods plus import retailing Several nominal and real rigidities

Models Description: cont. I Households: Preference displays habit formation in consumption Consumption goods is a CES bundle of home and imported goods They decide on consumption, savings, labor supply and set wages in a staggered fashion (see Erceg et al, 2000) Automatic updating of wages based on a weighted average between past ination and ination target Firms in the home goods sector: Intermediate producers have monopolistic power; technology combines labor and capital Producers are able to dierentiate domestic and foreign markets and set optimally prices in a staggered fashion (Calvo, 1983) As in nominal wages, there is an automatic updating of prices of varieties based on a weighted average between past ination and ination target
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Models Description: cont. II Importers: Importers of varieties have monopolistic power and set optimally their prices in a staggered fashion Again, automatic indexation to past ination and ination target Investment and Capital goods: Investment is CES composite of home and foreign goods Capital accumulation displays investment adjustment costs A representative rm in the commodity sector: No inputs; Production evolves stochastically Firm is owned by Government () and foreign investors (1 )

Models Description: cont. III Government: Lump-sum transfers; Ricardian Equivalence Government expenditure evolves stochastically. It consumes only Home goods Monetary policy is modelled as Taylor type rule: rt = r rt1 + (1 r ) C,t + (1 r )y yt + m,t Monetary policy instrument is the real interest rate Foreign Sector is introduced as exogenous variables: International price of the commodity exported Foreign output, ination and interest rate Foreign demand for Home goods depends on foreign output and foreign relative price of Home goods

Models Description: cont. IV Shocks: Technology: home goods productivity, investment adjustment costs, production of commodity Labor supply Demand: intertemporal substitution in consumption, government expenditure Monetary policy Foreign variables: commodity price, foreign output, ination and interest rate Risk premium Price of imports AR(1) processes and orthogonality among shocks

Estimation Bayesian methodology Some parameters are calibrated to match steady-state statistics or are taken from the literature C
PS YS PY Y

70% I 10% PX XPM M PY Y

40% 2%

C H p S

40% CA-GDP ratio -1.8% 1 1 H 2.2% (annual) 66% 8.9%

9

0.97 p S

Estimation: Data Observable variables: real GDP y, real consumption c, real investment inv, real exports x, commodity production yS , short-run real interest rate r, core ination C , real exchange rate rer, nominal devaluation e, real wages wr, real foreign GDP y , foreign interest rate i, and the international price of Copper p S Period: 1990:Q1 - 2006:Q1 How to get the cyclical component of these variables? We use an eclectic approach De-mean and de-trend: y, c, inv, x, wr, yS , y De-mean: rer, e, i C is expressed as deviation from its target HP lter: r
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Estimation: Priors
Prior dist Name mean/moda st. Dev. /deg. F shape 90% Interval L 1.00 1.00 Gamma 0.05 - 3.00 h 0.50 0.25 Beta 0.10 - 0.90 L 0.75 0.10 Beta 0.57 - 0.90 L 0.50 0.25 Beta 0.10 - 0.90 C 1.00 5.00 Inv. Gamma 0.66 - 3.05 I 1.00 5.00 Inv. Gamma 0.66 - 3.05 S 2.00 3.00 Inv. Gamma 1.27 - 9.78 HD 0.75 0.10 Beta 0.57 - 0.90 HD 0.50 0.25 Beta 0.10 - 0.90 HF 0.75 0.10 Beta 0.57 - 0.90 HF 0.50 0.25 Beta 0.10 - 0.90 F 0.75 0.10 Beta 0.57 - 0.90 F 0.50 0.25 Beta 0.10 - 0.90 r 0.75 0.15 Beta 0.47 - 0.95 + 1 1.50 0.15 Gamma 1.26 - 1.75 y 0.50 0.15 Gamma 0.28 - 0.77 1.00 4.00 Inv. Gamma 0.64 - 3.66 0.01 4.00 Inv. Gamma 0.01 - 0.04

11

Estimation: Priors and Posterior

Prior dist Name mean/moda st. Dev. /deg. F shape 90% Interval L 1.00 1.00 Gamma 0.05 - 3.00 h 0.50 0.25 Beta 0.10 - 0.90 L 0.75 0.10 Beta 0.57 - 0.90 L 0.50 0.25 Beta 0.10 - 0.90 C 1.00 5.00 Inv. Gamma 0.66 - 3.05 I 1.00 5.00 Inv. Gamma 0.66 - 3.05 S 2.00 3.00 Inv. Gamma 1.27 - 9.78 HD 0.75 0.10 Beta 0.57 - 0.90 0.50 0.25 Beta 0.10 - 0.90 HD 0.75 0.10 Beta 0.57 - 0.90 HF HF 0.50 0.25 Beta 0.10 - 0.90 F 0.75 0.10 Beta 0.57 - 0.90 F 0.50 0.25 Beta 0.10 - 0.90 r 0.75 0.15 Beta 0.47 - 0.95 + 1 1.50 0.15 Gamma 1.26 - 1.75 y 0.50 0.15 Gamma 0.28 - 0.77 1.00 4.00 Inv. Gamma 0.64 - 3.66 0.01 4.00 Inv. Gamma 0.01 - 0.04 Posterior dist moda mean st. dev. 0.00 0.00 0.00 0.72 0.74 0.04 0.85 0.86 0.01 0.38 0.33 0.06 0.99 1.05 0.12 1.00 1.07 0.20 1.75 1.60 0.38 0.98 0.98 0.00 0.99 0.99 0.00 0.65 0.66 0.08 0.03 0.03 0.00 0.68 0.69 0.04 0.03 0.03 0.01 0.60 0.60 0.06 1.35 1.34 0.10 0.09 0.09 0.02 0.50 0.55 0.11 0.01 0.01 0.00

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L 1000 500 0 8 6 4 2 0 1 100 0.5 50 0 0.4 200 4 2 0 100 0 0.2 0.4 S 0.6 0.8 1 0 0.5 1 prior post 8 6 4 2 0.5 1 1.5 L 2 2.5 0 3 2 0.2

h 30 20 10 0.4 C 0.6 0.8 0 0.4 0.5 0.6

0.7 I

0.8

1.5 1 0.5 1.5 HD 2 2.5 0 0.5 1 1.5 HD 2 2.5

100 50 0

4 HF

0.6 HF

0.8

0.2

0.4 F

0.6

0.8

8 6 4 2 0 0.4

0.4

0.5

0.6

0.7

0.8

0.2

0.4

0.6

0.8

0.5

0.6

0.7

0.8

Posterior distributions I 13

F 40 20 0 prior post 6 4 2 0.2 0.4 y 0.6 0.8 0 4 20 10 0 2 0.4

r 3 2 1 0.6 0.8 0 1.2

+1

1.4

1.6

200 100 0

0.2

0.4 aH

0.6

0 40

1 yS

0.01

0.02 y

0.03

6 4

40 20 2 0 0.2 0.4 i 40 6 4 2 0 0.2 0.4 0.6 0.8 0 0.2 0.4 0.6 0.8 0.6 0.8 0 0.2 0.4 6 4 2 0 0.2 0.4 0.6 0.8 0.6 0.8 20 0

0.2

0.4 L

0.6

0.8

20

Posterior distributions II 14

Empirical Assessment of the Estimated Model Using posterior mode of parameters: Impulse Response Functions Historical Decomposition

15

Commodity price shock Fiscal revenues Lump-sum taxes Private disposable income consumption Investment RER appreciates expansion in consumption and investment is more concentrated in imported goods GDP moderately Real wages , labor input Ination , r

16

y 0.1
Deviation SS (%) Deviation SS (%)

C 0
Deviation SS (%)

r 0.01

0.08 0.06 0.04 0.02 0 0 10 20

Quarters

0.02 0.04 0.06 0.08 0.1 0 10 20

Quarters

0.01

30

40

30

40

0.02

10

20
Quarters

30

40

0
Deviation SS (%)

rer

0.5
Deviation SS (%)

wr

0
Deviation SS (%)

labor

0.2 0.4 0.6 0.8

0.4 0.3 0.2 0.1

0.05 0.1 0.15 0.2

10

20
Quarters

30

40

10

20
Quarters

30

40

10

20
Quarters

30

40

0.5
Deviation SS (%)

2
Deviation SS (%)

inv

p S 10
Deviation SS (%)

0.4 0.3 0.2 0.1

1.5 1 0.5 0

8 6 4 2

10

20
Quarters

30

40

10

20
Quarters

30

40

10

20
Quarters

30

40

Responses to a commodity price shock

17

Foreign output shock PH RER appreciates Investment Labor ; real wages GDP Ination ; r Exchange rate exibility allows to isolate the economy from external conditions

18

y 0.08
Deviation SS (%) Deviation SS (%)

C 0
Deviation SS (%)

x 10

0.06 0.04 0.02 0

0.005

0.01

10

20
Quarters

30

40

0.015

10

20
Quarters

30

40

10

20
Quarters

30

40

0
Deviation SS (%)

rer

0.03
Deviation SS (%)

wr

0.15
Deviation SS (%)

labor

0.05 0.1 0.15 0.2

0.025 0.02 0.015 0.01

0.1 0.05 0 0.05

10

20
Quarters

30

40

10

20
Quarters

30

40

10

20
Quarters

30

40

0.03
Deviation SS (%)

0.2
Deviation SS (%)

inv

y 0.4
Deviation SS (%)

0.02

0.15 0.1 0.05 0

0.3 0.2 0.1 0

0.01

10

20
Quarters

30

40

10

20
Quarters

30

40

10

20
Quarters

30

40

Responses to a foreign output shock

19

Monetary policy shock Consumption, Investment GDP RER appreciates Hump-shaped responses of GDP labor input ; real wages ination ; max eect on yearly ination: 4 quarter

20

y 0.1
Deviation SS (%) Deviation SS (%)

C 0.02 0 0.02 0.04 0.06

Deviation SS (%)

0.4

0 0.1 0.2 0.3

0.2

10

20
Quarters

30

40

10

20
Quarters

30

40

0.2

10

20
Quarters

30

40

0
Deviation SS (%)

rer

0.02
Deviation SS (%)

wr

0.2
Deviation SS (%)

labor

0.2 0.4 0.6 0.8 1 0 10 20

Quarters

0.01 0 0.01 0.02

0 0.2 0.4 0.6

30

40

10

20
Quarters

30

40

10

20
Quarters

30

40

0.1
Deviation SS (%)

0.5
Deviation SS (%)

inv

m 0.4
Deviation SS (%)

0 0.1 0.2 0.3

0.3 0.2 0.1 0

0.5

10

20
Quarters

30

40

10

20
Quarters

30

40

10

20
Quarters

30

40

Responses to a monetary policy shock

21

y / aH 10 EE deviation (%) EE deviation (%) 5 0 5 10 1990 2000 Quarters y / m 10 EE deviation (%) EE deviation (%) 5 0 5 10 1990 2000 Quarters
y / F

y / yS 10 EE deviation (%) 5 0 5 10 1990 2000 Quarters y / L 10 EE deviation (%) 5 0 5 10 1990 2000 Quarters 10 10

y / p S 10 EE deviation (%)

y / y 10 EE deviation (%) 5 0 5 10 2000 Quarters y/g 10 EE deviation (%) EE deviation (%) 5 0 5 10 10 5 0 5 10 2000 Quarters 1990 1990

y / i 10 EE deviation (%) 5 0 5 10 2000 Quarters y / I 10 EE deviation (%) 5 0 5 10 2000 Quarters 1990 1990

y /

5 0 5 10 1990 2000 Quarters y / C

5 0 5 10 1990

2000 Quarters y /

5 0 5 10 1990 2000 Quarters

1990

2000 Quarters

10 EE deviation (%) 5 0 5 10 1990 2000 Quarters EE deviation (%)

10 5 0 5 10 1990 2000 Quarters

y: data y: model

Historical Decomposition of GDP

22

 1.5 1 EE deviation (%)

/ aH 1.5 1 EE deviation (%)

/yS 1.5 1 EE deviation (%)

/ p S 1.5 1 EE deviation (%)

/y 1.5 1 EE deviation (%) 0.5 0 0.5 1

/ i 1.5 1 EE deviation (%) 0.5 0 0.5 1

0.5 0 0.5 1 1990 2000 Quarters 1.5 1

C

0.5 0 0.5 1 1990 2000 Quarters 1.5 1

C

0.5 0 0.5 1 1990 2000 Quarters 1.5 1

C

0.5 0 0.5 1 1990 2000 Quarters 1.5 1

C

1990

2000 Quarters
C

1990

2000 Quarters
C

/ m

/ L

/ C

/g 1.5 1 EE deviation (%) 0.5 0 0.5 1

/ I 1.5 1 EE deviation (%) 0.5 0 0.5 1

EE deviation (%)

EE deviation (%)

EE deviation (%)

0.5 0 0.5 1 1990 2000 Quarters 1.5 1

C / F

0.5 0 0.5 1 1990 2000 Quarters

0.5 0 0.5 1 1990 2000 Quarters

C: C:

EE deviation (%)

0.5 0 0.5 1 1990 2000 Quarters

1990

2000 Quarters

1990

2000 Quarters

1.5 1 EE deviation (%) 0.5 0 0.5 1 2000 Quarters 1990 2000 Quarters

d a ta m o de l

EE deviation (%)

0.5 0 0.5 1 1990

Historical Decomposition of C

23

r / aH 3 EE deviation (%) EE deviation (%) 2 1 0 3

r / yS 3 EE deviation (%)

r / p S 3 EE deviation (%)

r / y 3 EE deviation (%) 2 1 0

r / i 3 EE deviation (%) 2 1 0

r /

2 1 0

2 1 0

2 1 0

1990

2000 Quarters r / m

1990

2000 Quarters r / L

1990

2000 Quarters r / C

1990

2000 Quarters r/g

1990

2000 Quarters r / I

1990

2000 Quarters r /

3 EE deviation (%) EE deviation (%) 2 1 0

3 EE deviation (%) 2 1 0

3 EE deviation (%) 2 1 0

3 EE deviation (%) 2 1 0

3 2 1 0 EE deviation (%) 2000 Quarters

3 2 1 0

1990

2000 Quarters
r / F

1990

2000 Quarters

1990

2000 Quarters

1990

2000 Quarters

1990

1990

2000 Quarters

3 EE deviation (%) EE deviation (%) 2 1 0

3 2 1 0

r: data r: model

1990

2000 Quarters

1990

2000 Quarters

Historical Decomposition of real interest rate

24

rer / aH 30 EE deviation (%) EE deviation (%) 20 10 0 10 20 1990 2000 Quarters rer / m 30 EE deviation (%) EE deviation (%) 20 10 0 10 20 1990 2000 Quarters
rer / F

rer / yS 30 EE deviation (%) 20 10 0 10 20 1990 2000 Quarters rer / L 30 EE deviation (%) 20 10 0 10 20 1990 2000 Quarters 30 30

rer / p S 30 EE deviation (%)

rer / y 30 EE deviation (%)

rer / i 30 EE deviation (%) 20 10 0 10 20 2000 Quarters rer / I 30 EE deviation (%) EE deviation (%) 20 10 0 10 20 30 20 10 0 10 20 2000 Quarters 1990 1990

rer /

20 10 0 10 20 1990 2000 Quarters rer / C

20 10 0 10 20 1990 2000 Quarters rer / g 30

20 10 0 10 20 1990

2000 Quarters rer /

10 0 10 20 1990 2000 Quarters

EE deviation (%)

20

20 10 0 10 20 1990 2000 Quarters

1990

2000 Quarters

30 EE deviation (%) EE deviation (%) 20 10 0 10 20 1990 2000 Quarters

30 20 10 0 10 20 1990 2000 Quarters

rer: data rer: model

Historical Decomposition of real exchange rate

25

Challenges Ahead Validate the relevance of transmission mechanisms described by model: History vs. forecasting Transmission of monetary policy through the exchange rate Determinants of consumption and investment Characterization of monetary policy How to obtain the cyclical components of variables in the data? Trends Structural breaks How to take (communicate) the results of the model to the policy environment

26