A Small Open Economy New Keynesian DSGE model for a foreign exchange constrained economy

May 26, 2011

By Sisay Regassa Senbeta


Firms in many low income countries depend entirely on imported capital and intermediate inputs. As a result, in these countries economic activity is considerably influenced by the capacity of the economy to import these inputs which, in turn, depends on the availability and cost of foreign exchange. In this study we introduce foreign exchange availability as an additional constraint faced by firms into an otherwise standard small open economy New Keynesian DSGE model. The model is then calibrated for a typical Sub Saharan African economy and the behaviour of the model in response to both domestic and external shocks is compared with the standard model. The impulse response functions of the two models are the same qualitatively for most of the variables though the model with foreign exchange constraint generates more variability in most of the variables than the standard model. This behaviour of the model with foreign exchange constraint is consistent with the stylized facts of low income countries. Furthermore, for variables for which the two models have di¤erent impulse response functions, the model with foreing exchange constraint is both theoretically consistent and matches the stylized facts.

Business cycles in developed economies may be over-studied given the relatively high cost of fluctuations in developing countries. The latter suffer from much larger volatility, in particular for consumption. This is one of the few papers looking at developing economies, and it introduces an interesting way to make fluctuations larger: limited availability of foreign reserves. This is like having a particular kind of incomplete markets that is only loosely connected to borrowing constraints. While I am not convinced the price setting is appropriate, I still think this is an interesting avenue to study fluctuations in developing economies.


Pro-Cyclical Unemployment Benefits? Optimal Policy in an Equilibrium Business Cycle Model

May 15, 2011

By Kurt Mitman and Stanislav Rabinovich


We study the optimal provision of unemployment insurance (UI) over the business cycle. We consider an equilibrium Mortensen-Pissarides search and matching model with risk-averse workers and aggregate shocks to labor productivity. Both the vacancy creation decisions of firms and the search effort decisions of workers respond endogenously to aggregate shocks as well as to changes in UI policy. We characterize the optimal history-dependent UI policy. We find that, all else equal, the optimal benefit is decreasing in current productivity and decreasing in current unemployment. Optimal benefits are therefore lowest when current productivity is high and current unemployment is high. The optimal path of benefits reacts non-monotonically to a productivity shock. Following a drop in productivity, benefits initially rise in order to provide short-run relief to the unemployed and stabilize wages, but then fall significantly below their pre-recession level, in order to speed up the subsequent recovery. Under the optimal policy, the path of benefits is pro-cyclical overall. As compared to the existing US UI system, the optimal history-dependent benefits smooth cyclical fluctuations in unemployment and deliver non-negligible welfare gains.

This is an interesting paper on optimal UI benefits. The interesting twist is that the Mortensen-Pissarides matching in the model allows to take into account the vacancy creation effect of changes in the outside option of unemployed workers. This leads to rich dynamics in UI benefits following an aggregate shock.

Solving Models with Incomplete Markets and Aggregate Uncertainty Using the Krusell-Smith Algorithm: A Note on the Number and the Placement of Grid Points

May 9, 2011

By Michal Horvath


This paper shows that numerical solutions to models with incomplete markets and aggregate uncertainty obtained using the Krusell and Smith (1998) algorithm are sensitive to the parameterization of the grid in the aggregate asset holdings direction. Higher moments of the cross-sectional distribution of asset holdings can be particularly affected, which is important for welfare analysis. Using grids that are denser around the mean of the ergodic distribution of individual asset holdings can enhance the consistency of the results across parameterizations. The accuracy of the approximation to individual decision functions can be much improved this way.

Solving heterogeneous agent models with aggregate shocks is very difficult. The Krusell-Smith method has considerably simplified this for some models, but it is not without pitfalls as this paper shows. The choice of grid points can matter and the solution id unfortunately to use more well placed points.

Business cycle dynamics under rational inattention

May 2, 2011

By Bartosz Maćkowiak and Mirko Wiederholt


We develop a dynamic stochastic general equilibrium model with rational inattention by households and firms. Consumption responds slowly to interest rate changes because households decide to pay little attention to the real interest rate. Prices respond quickly to some shocks and slowly to other shocks. The mix of fast and slow responses of prices to shocks matches the pattern found in the empirical literature. Changes in the conduct of monetary policy yield very different outcomes than in models currently used at central banks because systematic changes in policy cause reallocation of attention by decision-makers in households and firms.

A lot of interesting papers to choose from this week, and this paper caught my eye because of the premise that agents do not necessarily use all the information. Specifically, they neglect to check on the real interest rate as much as they would under perfect information. In fact, households make a conscious choice, given an estimate of the cost of deviating from the first best. That the impact of monetary policy policy is different from perfect attention models is not surprising, after all the nominal interest rate is the policy tool of the central bank, and households here are inattentive about the real interest rate. What I find particularly interesting is that different shocks have different impacts of the rigidity of prices, something that could help us understand why some prices are more flexible than others.