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AN ESTIMATED NEW KEYNESIAN POLICY MODEL FOR THE CZECH REPUBLIC Aleš Melecký Department of Economics Technical 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 article: From Inflation to Exchange Rate Targeting: Estimating the Stabilization Effects for a Small Open Economy (Ales Melecky and Martin Melecky) Conclusions Model 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! 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