Working Paper: CEPR ID: DP6027
Authors: Malin Adolfson; Stefan Lasen; Jesper Lind; Mattias Villani
Abstract: This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003) using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank's instrument rule. A key equation in the model - the uncovered interest rate parity (UIP) condition - is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence and volatility in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.
Keywords: Bayesian inference; DSGE model; DSGE-VAR model; DSGE-VECM model; Open economy
JEL Codes: C11; C53; E17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative correlation between the risk premium and the expected change in the nominal exchange rate (F31) | increased persistence and volatility of the real exchange rate (F31) |
| modifying the UIP condition (J65) | increased persistence and volatility of the real exchange rate (F31) |
| monetary policy shocks (E39) | response of the real exchange rate (F31) |
| modified UIP condition (J65) | monetary policy's effect on the real exchange rate becomes more gradual and persistent (E49) |