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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
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Outline of the Presentation• Motivation• Model• Data and Estimation Method• Estimation Results • Preview
– Impulse Response Analysis– From inflation to exchange rate targeting
• Conclusions
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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
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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
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Model Equations – Domestic Block • Phillips curve – inflation dynamics
• IS curve – output gap dynamics
• MP reaction function – interest rate dynamics
• UIP equation – exchange rate dynamics
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Model Equations – Foreign Block
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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)
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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
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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
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Estimation Results
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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)
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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