Macroeconomics II: Nominal Rigidities and Nominal

Exchange Rate

Dániel Baksa

ELTEcon

ELTEcon
 Macroeconomics II
Outline for the last two weeks:
Dániel Baksa

Introduction
1 Nominal rigidities and exchange rate Small open
economy
X Overview from last year: closed economy version of New-Keynesian
New-Keynesian model model
Households
Price and exchange rate determination in small open Firms
Fiscal policy
economy New-Keynesian models Monetary policy
Monetary policy regimes and nominal exchange rate Foreign economy
Equilibrium condition
fluctuations: flexible regimes, fixed regimes (instruments Log-linearization

with costs and benefits) Simulations

Technology shock
Applications: Scenario analysis and forecasting with Demand shock
Supply shock
New-Keynesian models in MATLAB/IRIS toolbox Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
2
 Macroeconomics II
!!!!!!!!!!!!!!!!!!!
Dániel Baksa

Textbooks Introduction

Walsh, C. E. (2003): Monetary Theory and Policy, Small open

economy
Chapter 6 New-Keynesian
model
Berg, A., Karam, P. & Laxton, D.: A Practical Households
Firms

Model-Based Approach to Monetary Policy Fiscal policy

Monetary policy

Analysis-Overview, IMF Working Paper, WP/06/80 Foreign economy

Equilibrium condition
Log-linearization

Additional readings: Simulations

Technology shock
Galı́, J. (JG, 2015): Monetary Policy, Inflation and the Demand shock
Supply shock
Business Cycle: An Introduction to the New Keynesian Premium shock

Framework and Its Applications, Chapter 1-3, 8 More practical

approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
3
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
Extending the basic New-Keynesian
model
New-Keynesian-model with open Households
Firms

economy... Fiscal policy

Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
4
 Macroeconomics II
Model in nutshell (1):
Dániel Baksa

Agents: households, firms and government

Introduction
Household in small open or closed economy Small open
utility maximization on infinite horizon economy
New-Keynesian
accumulate capital with investment model
Households
endogenous income: from capital and profit, transfers Firms
from government Fiscal policy
Monetary policy
supply labor Foreign economy
Equilibrium condition
pay taxes to the government Log-linearization

cumulate domestic savings, foreign debt Simulations

Technology shock
Fiscal policy Demand shock
Supply shock
receive taxes from households Premium shock

issue debt More practical

approach
finance own expenditures New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
5
 Macroeconomics II
Model in nutshell (2):
Dániel Baksa

Firms open economies Introduction

profit maximization (on infinite horizon) Small open
economy
products for consumption and investment New-Keynesian
rents capital from households model
Households
demand for labor Firms
Fiscal policy
households own the firm, then the profit part of Monetary policy

households’ income Foreign economy

Equilibrium condition
Log-linearization
Bonds market
Simulations
domestic: short run monetary policy determines the Technology shock
Demand shock
interest rate Supply shock
Premium shock
foreign: debt accumulation and endogenous interest
More practical
premium approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
6
 Macroeconomics II
Model solution
Dániel Baksa

Introduction

Small open
economy
1 Solving individual decision problem New-Keynesian
model
2 Checking the market clearing conditions Households
Firms
Fiscal policy
3 Checking the sufficient number of equations and Monetary policy
Foreign economy
variables Equilibrium condition
Log-linearization
4 Solving the system of forward-looking equations Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
7
 Macroeconomics II
Model solution
Dániel Baksa

Introduction

Small open
economy
1 Solving individual decision problem New-Keynesian
model
2 Checking the market clearing conditions Households
Firms
Fiscal policy
3 Checking the sufficient number of equations and Monetary policy
Foreign economy
variables Equilibrium condition
Log-linearization
4 Solving the system of forward-looking equations Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
8
 Macroeconomics II
Households’ problem:
Dániel Baksa

Households:
(
1−σ )
ξtC Ct − hC t−1 L1+η Introduction
Vt = e − Ψt t + Et βVt+1 Small open
1−σ 1+η economy
New-Keynesian
model
and budget constraint: Households
Firms
Fiscal policy
Z 1 Monetary policy

Profitt (i)di + Wt Lt + RtK Kt−1 + St Bt∗ + (1 + it−1 )Bt−1 = Foreign economy

Equilibrium condition
0 Log-linearization
∗ ∗
Pt Ct + Pt Invt + Pt Taxt + Bt + (1 + it−1 )St Bt−1 Simulations
Technology shock
Demand shock
where the capital accumulation: Supply shock
Premium shock
   More practical
Invt approach
Kt = Invt 1 − S + (1 − δ)Kt−1 New-Keynesian
Invt−1 framework
Small Open Economy
model
Dynamic properties

Summary
9
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

Two bonds: foreign and domestic ... model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
10
 Macroeconomics II
Households optimization
Dániel Baksa

Introduction
(
1−σ )
∗ ξtC Ct − hC t−1 L1+η Small open
Vt (Kt−1 , Bt−1 , Bt−1 , Invt−1 ) = e − Ψt t economy
1−σ 1+η New-Keynesian
model
+Et βVt+1 (Kt , Bt , Bt∗ , Invt ) Households
Firms
Fiscal policy
+λt Profitt + Wt Lt + RtK Kt−1 + St Bt∗ + (1 + it−1 )Bt−1 Monetary policy
Foreign economy
! Equilibrium condition
Log-linearization
∗ ∗
−Pt Ct − Pt Invt − Pt Taxt − Bt − (1 + it−1 )St Bt−1 Simulations
Technology shock
     Demand shock
Invt Supply shock
+µt Kt − Invt 1−S − (1 − δ)Kt−1 Premium shock
Invt−1
More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
11
 Macroeconomics II
FOCs
Dániel Baksa

Introduction
ξtC

−σ
Ct : e Ct − hC t−1 − Pt λt = 0 Small open
economy
ξtC New-Keynesian
Lt : −e Ψt Lηt + Wt λt = 0 model
Households
Bt : −λt + Et βVBt = 0 Firms
Fiscal policy
Bt : St λt + Et βVBt∗ = 0 Monetary policy
      Foreign economy
Invt Invt Invt Equilibrium condition
Invt : −Pt λt − µt 1 − S − S0 Log-linearization
Invt−1 Invt−1 Invt−1 Simulations
Technology shock
+Et βVInvt = 0 Demand shock
Supply shock
Kt : µt + Et βVKt = 0 Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
12
 Macroeconomics II
Envelope theorem
Dániel Baksa

Introduction

Small open
economy
New-Keynesian
VBt−1 = λt (1 + it−1 ) model
Households
∗
V ∗
Bt−1 = −λt St (1 + it−1 ) Firms
Fiscal policy

VKt−1 = λt RtK − µt (1 − δ) Monetary policy

Foreign economy
  2 Equilibrium condition

0 Invt Invt Log-linearization

VInvt−1 = −µt S Simulations
Invt−1 Invt−1 Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
13
 Macroeconomics II
Envelope theorem: expected values
Dániel Baksa

Introduction

Small open
economy
New-Keynesian
VBt = Et λt+1 (1 + it ) model
Households
V Bt∗ = −Et λt+1 St+1 (1 + it∗ ) Firms
Fiscal policy
K Monetary policy
VKt = Et λt+1 Rt+1 − µt+1 (1 − δ) Foreign economy
  2 Equilibrium condition

0 Invt+1 Invt+1 Log-linearization

VInvt = −Et µt+1 S Simulations
Invt Invt Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
14
 Macroeconomics II
Households solution
Dániel Baksa

−σ
Ψt Lηt = wt Ct − hC t−1

−σ Introduction
C
e ξt+1 Ct+1 − hC t 1 + it Small open
Et β C
−σ =1 economy
e ξt Ct − hC t−1 1 + πt+1 New-Keynesian
model
C
−σ
e ξt+1 Ct+1 − hC t St+1 1 + it∗
Households
Firms
Et β C
−σ =1 Fiscal policy
e ξt Ct − hC t−1 St 1 + πt+1 Monetary policy
Foreign economy
      Equilibrium condition
Invt 0 Invt Invt
1 − Qt 1 − S −S Log-linearization

Invt−1 Invt−1 Invt−1 Simulations

C
−σ 2 Technology shock
e ξt+1 Ct+1 − hC t
 
0 Invt+1 Invt+1 Demand shock
= Et β C
−σ Qt+1 S Supply shock

e ξt Ct − hC t−1 Invt Invt Premium shock

More practical
C
−σ approach
e ξt+1 Ct+1 − hC t K

New-Keynesian
Q t = Et β C
−σ rt+1 + Qt+1 (1 − δ) framework
e ξt Ct − hC t−1 Small Open Economy
model
Dynamic properties

Summary
15
 Macroeconomics II
Production structure:
Dániel Baksa

Introduction
1 Retailers: Small open
economy
Perfect competition New-Keynesian
model
Collecting intermediate goods Households
Selling the goods for consumption, investment and Firms
Fiscal policy
export Monetary policy
Foreign economy
2 Producers: Equilibrium condition
Log-linearization
Monopolistic competition Simulations
Calvo pricing Technology shock
Demand shock
Using capital, labor and import Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
16
 Macroeconomics II
Retailers (1)
Dániel Baksa

Introduction

Small open
Solving a cost-minimization problem with the following economy
New-Keynesian
production function: model
Households
Firms
Fiscal policy
Monetary policy
θ
Z 1 θ−1
 θ−1 Foreign economy
Equilibrium condition
Yt = Yt (i) θ di Log-linearization
0 Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
17
 Macroeconomics II
Retailers (2)
Dániel Baksa

Introduction
That implies the demand function:
Small open
economy
 −θ New-Keynesian
Pt (i) model
Yt (i) = Yt Households
Pt Firms
Fiscal policy
Monetary policy
and the price index Foreign economy
Equilibrium condition
Log-linearization
1
Z 1  1−θ Simulations
1−θ
Pt = Pt (i) di Technology shock
Demand shock
0 Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
18
 Macroeconomics II
Producers (1)
Dániel Baksa

Profit maximization: Introduction

Small open
profitt (i) = Pt (i)Yt (i) − Wt Lt (i) − RtK Kt−1 (i) − St Pt∗ Mt (i) economy
New-Keynesian
model
where Households
Firms
γ Fiscal policy
Yt (i) = At Kt−1 (i)α Lt (i)1−α Mt (i)1−γ

Monetary policy
Foreign economy
Equilibrium condition

and the firm knows the demand Log-linearization

Simulations
 −θ Technology shock
Pt (i) Demand shock
Yt (i) = Yt Supply shock
Pt Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
19
 Macroeconomics II
Producers (2)
Dániel Baksa

We can solve it simply:

Introduction
1 Derive the marginal cost from cost minimzation
Small open
2 With marginal cost we can write the price setting economy
New-Keynesian
problem: model
Households
∞ Firms
Fiscal policy
X
n
Et ω ∆t,t+n (Pt (i)Yt+n (i) − MCt+n Yt+n (i)) −→ max
∗ Monetary policy
Pt (i) Foreign economy
n=0
Equilibrium condition
Log-linearization
and with demand functions Simulations
Technology shock
∞  −θ  −θ ! Demand shock
X Pt (i) Pt (i)
Et ω n ∆t,t+n Yt+n Pt (i) − MCt+n −→ max
∗
Supply shock

n=0
Pt+n Pt+n Pt (i) Premium shock

More practical
approach
It is the same as before New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
20
 Macroeconomics II
Producers (3)
Dániel Baksa

Introduction

Small open
economy
New-Keynesian
Using the same solution: model
Households
Firms
∞ −θ Fiscal policy
Pt∗ (i)
  
X Pt θ Pt+n
Et ω n ∆t,t+n Yt+n − mct+n =0 Monetary policy
Foreign economy
n=0
Pt+n Pt θ − 1 Pt Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
21
 Macroeconomics II
Producers (4)
Dániel Baksa

Introduction
Cost minimization:
Small open
1−α γ
 h i 
K ∗ α
Rt Kt−1 (i) + Wt Lt (i) + Pt St Mt (i) + MCt (i) Yt (i) − At Kt−1 (i) Lt (i) Mt (i)
1−γ economy
New-Keynesian
model

FOCs: Households
Firms
Fiscal policy
γ−1 Monetary policy
RtK = MCt (i)γαAt Kt−1 (i)α Lt (i)1−α Mt (i)1−γ Kt−1 (i)α−1 Lt (i)1−α

Foreign economy
γ−1 Equilibrium condition
Wt = MCt (i)γ(1 − α)At Kt−1 (i)α Lt (i)1−α Mt (i)1−γ Kt−1 (i)α Lt (i)−α

Log-linearization

∗ 1−α γ
α
Mt (i)−γ Simulations
 
Pt St = MCt (i)(1 − γ)At Kt−1 (i) Lt (i)
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
22
 Macroeconomics II
Producers (5)
Dániel Baksa
Demand functions:
Yt (i)
RtK = MCt (i)γα
Kt−1 (i)
Yt (i) Introduction
Wt = MCt (i)γ(1 − α)
Lt (i)
Small open
Yt (i) economy
Pt∗ St = MCt (i)(1 − γ) New-Keynesian
Mt (i) model
Households

Introducing real exchange rate definition: Firms

Fiscal policy
Monetary policy
Pt∗ St Foreign economy
zt = Equilibrium condition
Pt Log-linearization

Simulations
Then the real demands: Technology shock
Demand shock
Supply shock
Yt (i)
rtK = mct (i)γα Premium shock
Kt−1 (i) More practical
Yt (i) approach
wt = mct (i)γ(1 − α) New-Keynesian
Lt (i) framework
Small Open Economy
Yt (i) model
zt = mct (i)(1 − γ) Dynamic properties
Mt (i)
Summary
23
 Macroeconomics II
Producers (6)
Dániel Baksa

Plugging back these demand equations to the production

function:
" !α  1−α #γ  Introduction
Yt (i) Yt (i) Yt (i) 1−γ

Yt (i) = At mct (i)γα mct (i)γ(1 − α) mct (i)(1 − γ)
rtK wt zt Small open
" !α  #γ  economy
1 1 1−α 1 1−γ
 
New-Keynesian
1 = At mct (i)γα mct (i)γ(1 − α) mct (i)(1 − γ)
rtK wt zt model
α γ Households
rtK
" ! #
1 1

wt
1−α 
zt
 1−γ Firms
mct (i) = Fiscal policy
At γ α 1−α 1−γ
Monetary policy
Foreign economy
Equilibrium condition
Since the marginal cost is function only the aggregate Log-linearization

prices, then the marginal cost can written as the aggregate Simulations
Technology shock
marginal cost also. Demand shock
Supply shock
Premium shock
"  α  1−α #γ  1−γ
1 1 rtK wt zt More practical
mct = approach
At γ α 1−α 1−γ New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
24
 Macroeconomics II
Government budget constraint
Dániel Baksa

Introduction

Small open
economy
New-Keynesian
Collects taxes, has expenditures and take debts from model
Households
households: Firms
Fiscal policy
Monetary policy
Pt Govt + (1 + it−1 )Debtt−1 = Pt Taxt + Debtt Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
25
 Macroeconomics II
Monetary policy
Dániel Baksa

Introduction

Small open
economy
Follows a forward-looking interest rate rule: New-Keynesian
model
Households
 φS !1−ρi Firms
St+1 Fiscal policy

1 + it = Et (1 + it−1 )ρi (1 + r¯t )(1 + πt+1 )φπ Monetary policy

Foreign economy
St Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
26
 Macroeconomics II
Foreign economy
Dániel Baksa
Export demand:
 −φ
1
Xt = GDPt∗ Introduction
zt
Small open
economy
Trade-balance: New-Keynesian
model
Households

TBt = Xt − zt Mt Firms
Fiscal policy

= − zt bt∗ − zt (1 + rt−1
∗ ∗

Monetary policy
TBt )bt−1 Foreign economy
Equilibrium condition
Log-linearization

Foreign interest rate: Simulations

Technology shock
Demand shock
zt bt∗ zb ∗
 
Supply shock
ϕr ∗ ln −ln ξtr
1 + rt∗ = (1 + r ∗ )e GDPt GDP
e Premium shock

More practical
approach
Foreign prices are exogenous: New-Keynesian
framework
Small Open Economy
model
1 + it∗ = (1 + rt∗ )(1 + πt+1
∗
) Dynamic properties

Summary
27
 Macroeconomics II
Model solution
Dániel Baksa

Introduction

Small open
economy
1 Solving individual decision problem New-Keynesian
model
2 Checking the market clearing conditions Households
Firms
Fiscal policy
3 Checking the sufficient number of equations and Monetary policy
Foreign economy
variables Equilibrium condition
Log-linearization
4 Solving the system of forward-looking equations Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
28
 Macroeconomics II
Merging the constraints
Dániel Baksa
Overall profits are
Z 1
Profitt (i)di = Pt Yt − Wt Lt − RtK Kt−1 − St Pt∗ Mt
0 Introduction

Small open
Plugging back to the households’ constraint: economy
New-Keynesian
model

Pt Yt − St Pt∗ Mt + St Bt∗ + (1 + it−1 )Bt−1 = Households

Firms
Fiscal policy
∗ ∗
Pt Ct + Pt Invt + Pt Taxt + Bt + (1 + it−1 )St Bt−1 Monetary policy
Foreign economy
Equilibrium condition
Log-linearization
Using the government constraint and Bt = Debtt : Simulations
Technology shock
Demand shock
Pt Govt + (1 + it−1 )Debtt−1 = Pt Taxt + Debtt Supply shock
Premium shock

More practical
And we have approach
New-Keynesian
framework
Pt Yt − St Pt∗ Mt = Small Open Economy
model
Dynamic properties
Pt Ct + Pt Invt + Pt Govt − St Bt∗ − (1 + it−1
∗ ∗


)St Bt−1 Summary
29
 Macroeconomics II
Equilibrium
Dániel Baksa

In real terms:
Introduction
Yt − zt Mt = Ct + Invt + Govt − zt bt∗ − (1 + rt−1
∗ ∗


)zt bt−1 Small open
economy
Yt − zt Mt = Ct + Invt + Govt + TBt New-Keynesian
model
Yt − zt Mt = Ct + Invt + Govt + Xt − zt Mt Households
Firms
Fiscal policy
Monetary policy
Total production should be equal with total demands: Foreign economy
Equilibrium condition
Log-linearization

Yt = Ct + Invt + Govt + Xt Simulations

Technology shock
Demand shock

But for the GDP we use another definition: Supply shock

Premium shock

More practical
GDPt = Ct + Invt + Govt + TBt approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
30
Log-linearized model (1)
Households:
h b h 1−h 1−h
Cbt = Ct−1 + Et Cbt+1 − (it − Et πt+1 ) + (ξtC − Et ξt+1
C
)
1+h 1+h σ(1 + h) σ(1 + h)
bt + σ
 
wbt = Ψ
b t + ηL Cbt − hCbt−1
1−h
c t = 1 Inv
Inv c t−1 + β Et Inv c t+1 + 1
Qbt
1+β 1+β φInv (1 + β)
bt + (it − Et πt+1 ) = (1 − β(1 − δ))Et rdK
Q t+1 + β(1 − δ)Et Q bt+1
dSt+1 + it∗ = it

Firms:
 
K
mc t + (1 − α)w
c t = γ αrc bt + (1 − γ)zt − Abt
K c t + Ybt − K
rct = mc
bt−1
w c t + Ybt − L
bt = mc bt
c t + Yt − M
zbt = mc b bt
(1 − ω)(1 − βω)
πt = mc
c t + βEt πt+1
ω
Log-linearized model (2)
Monetary policy:
it = ρi it−1 + (1 − ρi ) (¯
rt + φπ Et πt+1 )
Real exchange rate:
zbt − zbt−1 = dSt + πt∗ − πt
Market equilibrium:
Y b C b Inv c Gov d X b
Yt = Ct + Inv t + Gov t + Xt
GDP GDP GDP GDP GDP
[ t = C Cbt + Inv Inv
GDP c t + Gov Gov
d t + TB TB ct
GDP GDP GDP GDP
Trade-balance:
c t = X Xbt − zM zbt + M
 
TB bt
TB ∗ TB
zb  z(1 + r ∗ )b ∗  
∗ ∗ ∗
TB t = −
c zbt + bt −
b zbt + rt−1 + bt−1
b
TB TB
Capital accumulation:
c t = Kbt − (1 − δ)Kbt−1
δ Inv
Log-linearized model (3)

Foreign block:

it∗ = rt∗ + Et πt+1

∗

zt bt∗
\
rt∗ = ϕr ∗ + ξtr
GDPt
π∗
πt∗ = ρπ∗ πt−1
∗
+ t t
∗
Xbt [ t + φb
= GDP zt

where

zt bt∗
\ ∗
= zbt + bbt∗ − GDP
[t
GDPt
IRF: Technology shock
Nominal interest rate (%) Inflation (%, QoQ) Nominal Exchange rate (%)
0.02 0.2 0.6

0
0 0.4
-0.02
-0.2 0.2
-0.04

-0.06 -0.4 0
5 10 15 20 5 10 15 20 5 10 15 20

Marginal cost (%) Real wage (%) Real Exchange Rate (%)
0.5 2 1

0
1 0.8
-0.5
0 0.6
-1

-1.5 -1 0.4
5 10 15 20 5 10 15 20 5 10 15 20

GDP (%) Consumption (%) Investment (%)

2 0.1 4
GDP
Production
1 0.05 2

0 0 0

-1 -0.05 -2
5 10 15 20 5 10 15 20 5 10 15 20
IRF: Demand shock
Nominal interest rate (%) Inflation (%, QoQ) Nominal Exchange rate (%)
0.08 0.4 0.4

0.06 0.3
0.2
0.04 0.2
0
0.02 0.1

0 -0.2 0
5 10 15 20 5 10 15 20 5 10 15 20

Marginal cost (%) Real wage (%) Real Exchange Rate (%)
1.5 4 0.2

1
2 0
0.5
0 -0.2
0

-0.5 -2 -0.4
5 10 15 20 5 10 15 20 5 10 15 20

GDP (%) Consumption (%) Investment (%)

1 1.5 1
GDP
Production 1 0
0
0.5 -1
-1
0 -2

-2 -0.5 -3
5 10 15 20 5 10 15 20 5 10 15 20
IRF: Supply shock
Nominal interest rate (%) Inflation (%, QoQ) Nominal Exchange rate (%)
0.15 1.5 0.9

0.1 1 0.8

0.05 0.5 0.7

0 0 0.6

-0.05 -0.5 0.5

5 10 15 20 5 10 15 20 5 10 15 20

Marginal cost (%) Real wage (%) Real Exchange Rate (%)
6 15 0

4 10 -0.2

2 5 -0.4

0 0 -0.6

-2 -5 -0.8
5 10 15 20 5 10 15 20 5 10 15 20

GDP (%) Consumption (%) Investment (%)

2 0 2
GDP
Production -0.05
0 0
-0.1
-2 -2
-0.15

-4 -0.2 -4
5 10 15 20 5 10 15 20 5 10 15 20
IRF: Premium shock
Nominal interest rate (%) Inflation (%, QoQ) Nominal Exchange rate (%)
0.03 0.2 1.5

0.02
0.1 1
0.01
0 0.5
0

-0.01 -0.1 0
5 10 15 20 5 10 15 20 5 10 15 20

Marginal cost (%) Real wage (%) Real Exchange Rate (%)
1 0.6 1

0.4
0.5 0.5
0.2
0 0
0

-0.5 -0.2 -0.5

5 10 15 20 5 10 15 20 5 10 15 20

GDP (%) Consumption (%) Investment (%)

0.2 0 0.5
GDP
0 Production
-0.02 0
-0.2
-0.04 -0.5
-0.4

-0.6 -0.06 -1
5 10 15 20 5 10 15 20 5 10 15 20
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian
Nice, but complicated and not always model
Households

intuitive ... Firms

Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
38
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

... another way possible? model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
39
World of macroeconomic models

Structural macro models

Theoretical
consistency
Semi-structural models

Statistical /
econometric
methods
Empirical
validity
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

New-Keynesian, semi-structural model model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
41
 Macroeconomics II
Semi-structural approach (1):
Dániel Baksa

WLOG: the main channels and parameters are not

taken from a micro-based problem, but the core
behavior is the same
Introduction

Small open
economy
New-Keynesian
model
Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
42
 Macroeconomics II
Semi-structural approach (1):
Dániel Baksa

Introduction
Dynamic-IS curve (Euler equation in RBC world, Small open
Aggregate Demand function in Keynesian world): economy
New-Keynesian
model
Yt = Yt e − α1 (it − πte ) + Y
t
Households
Firms
Fiscal policy

where Monetary policy

Foreign economy
Equilibrium condition
Y : output gap (GDP % from its potential level) Log-linearization
i: the interest rate Simulations
π: the inflation Technology shock
Demand shock
i − π e : real interest rate Supply shock
Premium shock
The output gap is negative function of real interest More practical
approach
rate, and function of (hybrid) expectation: New-Keynesian
framework
Small Open Economy
Yte = α2 Yt+1 + (1 − α2 )Yt−1 model
Dynamic properties

Summary
42
 Macroeconomics II
Semi-structural approach (2):
Dániel Baksa

Introduction
New-Keynesian Phillips curve (Aggregate supply curve Small open
economy
in Keynesian world): New-Keynesian
model
Households
πt = πte + β1 Yt + πt Firms
Fiscal policy
Monetary policy
Foreign economy
The inflation is positive function of output gap and Equilibrium condition
Log-linearization
(hybrid) expectations: Simulations
Technology shock

πte = β2 πt+1 + (1 − β2 )πt−1 Demand shock

Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
43
 Macroeconomics II
Semi-structural approach (3):
Dániel Baksa

Introduction

Small open
economy
Monetary policy reaction (Taylor rule): New-Keynesian
model

it = ρi it−1 + 1 − ρi φπ πte + it

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Increasing inflation: central bank increases the interest Equilibrium condition
Log-linearization
rate to stimulate the domestic demand and offset the
Simulations
inflationary pressure Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
44
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

Small Open Economy model model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
45
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

Small Open Economy model model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
46
Literally, this case ...
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian
Small individuals can not influence the model
Households
whole universe Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
48
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

Small Open Economy model model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
49
 Macroeconomics II
Additional variables: nominal/real exchange rate
Dániel Baksa
Small open economy with flexible nominal exchange
rate (S):
St = Ste − (it − it∗ + Premt ) Introduction

where the Seis the nominal exchange rate expectation, Small open
economy
Prem country-specific risk premium, i ∗ foreign interest New-Keynesian
model
rate. Households

Open financial account, without any capital control Firms

Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
SOE = goods and services can freely float into the Log-linearization

country, hence the foreign/import prices also influence Simulations

Technology shock
the domestic. Demand shock
Supply shock
Real exchange rate (Z ) express the relative price Premium shock

differentials among the domestic and foreign economies: More practical

approach
New-Keynesian
Zt = St + Pt∗ − Pt framework
Small Open Economy
model

where the Pt = πt + Pt−1 domestic, Pt∗ = πt∗ + Pt−1

∗ Dynamic properties

Summary
foreign price index 50
 Macroeconomics II
Additional terms in IS-curve
Dániel Baksa

IS-curve and exchange rate: Introduction

Small open
economy
Yt = Yte + α1 (α4 Zt − (1 − α4 ) (it − πte )) + α3 Yt∗ + Y
t New-Keynesian
model
Households
where Yt∗ foreign demand. Firms
Fiscal policy
Monetary policy
Positive real exchange rate = relative cheapness of Foreign economy
Equilibrium condition
domestic goods, leads to improve in the net-export Log-linearization

position Simulations
Technology shock
Demand shock
Positive foreign demand (lion) intensifies the domestic Supply shock
Premium shock
production and export (mouse)
More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
51
 Macroeconomics II
Additional terms in Phillips-curve
Dániel Baksa

Phillips-curve and exchange rate:

Introduction

Small open
πt = πte + β1 (β3 Yt + (1 − β3 )Zt ) + πt economy
New-Keynesian
model
Households
Firms
Fiscal policy
Positive real exchange rate = increase in import prices Monetary policy
Foreign economy
that curb the domestic prices Equilibrium condition
Log-linearization
Monetary policy: Simulations
Directly not react to exchange rate in flexible regimes Technology shock
Demand shock
(next lecture we change it!) Supply shock
Premium shock
... but indirectly influence the nominal exchange rate
More practical
path and volatility approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
52
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

Dynamic properties model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
53
 Macroeconomics II
Impulse response function: Foreign Demand
Dániel Baksa
shock
Nominal interest rate Inflation Output gap
0.3 0.4 1.5
Foreign Introduction
0.3
0.2 1 Small open
0.2 economy
0.1 0.5
New-Keynesian
model
0.1
Households
0 0 Firms
0 Fiscal policy
Monetary policy
-0.1 -0.1 -0.5 Foreign economy
5 10 15 20 5 10 15 20 5 10 15 20 Equilibrium condition
Quarters Quarters Quarters Log-linearization

Nominal exchange rate Real exchange rate Simulations

0.1 0.25
Technology shock
Demand shock
0.2 Supply shock
Premium shock
0
0.15
More practical
approach
0.1
-0.1 New-Keynesian
framework
0.05 Small Open Economy
model
Dynamic properties
-0.2 0
5 10 15 20 5 10 15 20 Summary
Quarters Quarters
54
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
Question: what happens in domestic New-Keynesian
model

economy during foreign demand shock? Households

Firms

Draw it! Fiscal policy

Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
55
 Macroeconomics II
Impulse response function: Foreign demand
Dániel Baksa
shock
Nominal interest rate Inflation Output gap
0.3 0.4 1.5
Domestic Introduction
0.3 Foreign
0.2 1 Small open
0.2 economy
0.1 0.5
New-Keynesian
model
0.1
Households
0 0 Firms
0 Fiscal policy
Monetary policy
-0.1 -0.1 -0.5 Foreign economy
5 10 15 20 5 10 15 20 5 10 15 20 Equilibrium condition
Log-linearization

Nominal exchange rate Real exchange rate Simulations

0.1 0.25
Technology shock
Demand shock
0.05
0.2 Supply shock
Premium shock
0
0.15
More practical
-0.05
approach
0.1
-0.1 New-Keynesian
framework
0.05 Small Open Economy
-0.15 model
Dynamic properties
-0.2 0
5 10 15 20 5 10 15 20 Summary
56
 Macroeconomics II
Foreign Demand shocks
Dániel Baksa

Foreign Demand shock in foreign (or closed) economy: Introduction

Small open
Demand shock increases the inflationary pressure in the economy
economy New-Keynesian
model
Central bank offsets the excess demand with the hike in Households
Firms
interest rate Fiscal policy
Monetary policy
Foreign demand shock hits the domestic economy as Foreign economy
Equilibrium condition
well: Log-linearization

Imported inflationary pressure increases the domestic Simulations

Technology shock
prices Demand shock
Slow reaction in domestic interest rate offsets the Supply shock
Premium shock
depreciation pressure on currency More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
57
 Macroeconomics II
Take home message
Dániel Baksa

Semi-structural approach:
easy-to-use way to describe an economy Introduction

with small cost we can change it to small open economy Small open
economy
version New-Keynesian
model
Additional features Households
Firms
Nominal and real exchange rate determination Fiscal policy

Exchange rate feeds into domestic demand and prices Monetary policy
Foreign economy
Monetary policy indirectly stabilize the real exchange Equilibrium condition
Log-linearization
rate Simulations
Dynamic properties: Technology shock
Demand shock
Supply shock
Monetary policy stabilize the economy via output gap Premium shock
and (!) real exchange rate More practical
Exchange rate channel contributes to the domestic price approach
New-Keynesian
dynamics framework
Small Open Economy
model
Dynamic properties

Summary
58
 Macroeconomics II

Dániel Baksa

Introduction

Small open
economy
New-Keynesian

Thank you for your attention! model

Households
Firms
Fiscal policy
Monetary policy
Foreign economy
Equilibrium condition
Log-linearization

Simulations
Technology shock
Demand shock
Supply shock
Premium shock

More practical
approach
New-Keynesian
framework
Small Open Economy
model
Dynamic properties

Summary
59