Measuring the Stance of Monetary Policy in a Small Open Economy: A Dynamic Stochastic General Equilibrium Approach

This paper develops and estimates a dynamic stochastic general equilibrium model of a small open economy which provides a quantitative description of the monetary transmission mechanism, yields a mutually consistent set of indicators of inflationary pressure together with confidence intervals, and facilitates the generation of relatively accurate forecasts. The model features short run nominal price and wage rigidities generated by monopolistic competition and staggered reoptimization in output and labour markets. The resultant inertia in inflation and persistence in output is enhanced with other features such as habit persistence in consumption and labour supply, adjustment costs in housing and capital investment, and variable capital utilization. Incomplete exchange rate pass through is generated by monopolistic competition and staggered reoptimization in the import market. Cyclical components are modeled by linearizing equilibrium conditions around a stationary deterministic steady state equilibrium which abstracts from long run balanced growth, while trend components are modeled as random walks while ensuring the existence of a well defined balanced growth path. Parameters and unobserved components are jointly estimated with a novel Bayesian full information maximum likelihood procedure, conditional on prior information concerning the values of parameters and trend components.