Reassessing the Effects of Foreign Monetary Policy on Output: New Evidence from Structural and Agnostic Identification Procedures

We investigate the propagation of a foreign monetary policy shock over a small open economy, in particular over the Chilean economy. Our motivation is based on the ongoing period of monetary normalization already started by the Fed. We follow Canova (2007) and compare the impulse response functions of structural VAR models and a DSGE model tailored for the Chilean economy. We use the recursive VAR model of Sims (1980) and an extension of the agnostic VAR model of Uhlig (2005) and Arias et al. (2014) for small open economies following Koop and Korobilis (2010). The results suggest that the recursive VAR model does not properly identify the shock, and its implications are counterintuitive. On the contrary, beyond the quantitative differences, we find that the responses of the agnostic VAR model are qualitatively in line with those of the DSGE model except for output. However, the transmission of the shock to the local economy is limited but more persistent according to the DSGE model. Finally, we spot different policy implications arising from both models. According to the agnostic VAR model, the central bank does not need to raise its policy rate because the drop in activity offsets any jump in inflation; whereas in the DSGE model the rise in prices is partially accommodated by an increase in the policy rate. Thus, this comparison motivates an interesting discussion for the policymaker.