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

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.

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