AN ESTIMATED NEW KEYNESIAN POLICY AN ESTIMATED NEW KEYNESIAN POLICY

MODEL FOR THE CZECH REPUBLICMODEL FOR THE CZECH REPUBLIC

Aleš Melecký

Department of EconomicsTechnical University of Ostrava

Outline of the Presentation• Motivation• Model• Data and Estimation Method• Estimation Results • Preview

– Impulse Response Analysis– From inflation to exchange rate targeting

• Conclusions

Motivation

• 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

• 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 • Phillips curve – inflation dynamics

• IS curve – output gap dynamics

• MP reaction function – interest rate dynamics

• UIP equation – exchange rate dynamics

Model Equations – Foreign Block

Data

• 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• 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

• 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

Estimation Results – Phillips 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• 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 rate elasticity 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• CNB and ECB smooth their interest rates, where ECB

policy rate shows slightly more inertia

• ECB reaction to 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

• 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

• 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-form used to generate impulse responses of domestic variables to selected shocks

Impulse Response Analysis

• 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 Analysis

• 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 Analysis

• 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 Analysis

• Foreign IS shock hits the Czech economy

• Foreign IS shock » ↑foreign demand » ↑Czech output gap» ↑inflation & ↑EA inflation » 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 steady state

Impulse Response Analysis

• Foreign AS shock hits the Czech economy

• Foreign AS shock » ECB ↑interest rate » ↑real interest rate » CZK depreciates 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 Analysis

• 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 Analysis

• 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

• Estimating CB´s loss function

• Optimalization of inflation targeting and movement to exchange rate targeting

• More in our articleMore in our article: : From Inflation to Exchange From Inflation to Exchange Rate Targeting: Estimating the Stabilization Rate Targeting: Estimating the Stabilization Effects for a Small Open EconomyEffects for a Small Open Economy((AleAless Meleck Meleckyy and Martin Meleck and Martin Melecky)y)

ConclusionsModel 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!

ales.melecky.ekf@vsb.cz