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Simulation, Estimation and Welfare Implications of Monetary Policies in a 3- Country NOEM Model Joseph Plasmans University of Antwerp and Tilburg University Tomasz Michalak Jorge Fornero Universities of Antwerp and Liverpool University of Antwerp NBB 4th biannual Conference Price and Wage Rigidities in an Open Economy 12 – 13 October 2006

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2 Objectives of the Project To develop a three-country NOEM model with asymmetric countries in size: a small and a large open economy, being members of a monetary union (MU) and the third (large) country being the rest of the world (RoW); To conduct numerical simulations, econometric estimations and welfare implications of alternative monetary policies (MPs), taking account of nominal price and wage rigidities. Application: NL, RoEMU and the RoW (USA).

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3 Related literature on two-country MU models Practically all up-to-date NOEM models of an MU are two-country settings. Interestingly: Benigno (2004) shows that the Common CBs MP must take account of (relative) rigidities in the regions when designing a welfare maximizing MP rule. Pytlarczyk (2005) develops a two-region model for the euro area with a particular focus on analyzing the German economy within the EMU. The interesting element of his work is the utilization of disaggregated information, i.e. national accounts data, for econometric estimation along with "synthetic" euro area data.

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4 Basic characteristics of the model: New-Keynesian open-economy model with habit formation in consumption Savings carry over between periods via domestic and foreign assets Asset markets are incomplete Tradable and non-tradable goods Final and intermediate goods Separate modeling of intermediate goods sectors Multi-level (nested) CES consumption and production functions Staggered Calvo price and wage settings in each level of production.

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5 Consumer i, aggregate consumption Nested CES consumption in 2 levels: Aggregate consumption - 1st level Dom. tradable consumption - 2nd level

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6 Consumer i, budget constraint Consumer i´s budget constraint (CBC): Risk premium faced by the small open economy when buying foreign assets: where is an appropriate function, e.g.:

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7 Consumer i, expected utility function Consumer i´s period utility function: Variables are in per capita terms. Countries size is found computing the real GDP of each region (h, RoMU and RoW) with corresponding accumulated shares: n 1, n 2 and n 3 = 1. These shares are used in building a common MP rule for the MU.

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8 Consumer i, FOCs

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9 Final goods firm j´s production function Nested CES production function with tradable and non-tradable final goods (i.e. sectors m = FT, FN): where:

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10 Illustration of the structure of the 2nd level of aggregation: sectoral flows of intermediate goods FN h FT h VN h VT h FT U FN U VTUVTU VN U FN W FT W VN W VT W

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11 Intermediate goods firms Intermediate goods modeling: 1.Literature approach – in most of the papers a fraction of imported final goods is used as an input in the production process. In other words, there is no separate modeling of intermediate goods sectors as e.g. Smets and Wouters (2002), Erceg et al. (2000) and Corsetti and Dedola (2002). 2.Alternative approach – intermediate goods are explicitly modeled as in Dellas (2005). DIFFERENCE: the literature approaches exchange rate movements as a result of the expenditure switching effect in intermediate goods, which operates on the same level as final goods. Our model allows for expenditure switching effects on two different levels, i.e. FT and VT goods.

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12 Firms j, intermediate goods production function Firm j, which produces intermediate goods, uses labor as input. The production functions for sectors m = VT and VN are: We assume full employment; therefore, the whole endowment of labor is allocated in FT, FN, VT and VN sectors:

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13 Price and Wage Stickiness Each firm in each production sector FT, FN, VT and VN sets prices in a staggered way (in the Calvo-scheme). Also, the same pricing is assumed for the non-producing importers in the MF and MV sectors. Also wages in each production sector FT, FN, VT and VN are sticky. Imperfect pass-through is introduced by assuming different Calvo price-setting parameters in the import sectors MF and MV on both final and intermediate goods levels.

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14 Taylor MP rules in the MU 1.Rule I: standard Taylor rule for an MU, extended with weighted tradable and non-tradable outputs: 2.Rule II: Rule I + smoothing:

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15 Taylor MP rules in the MU (con´t) Rule III: Rule II + annualized wage inflation

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16 Net Foreign Assets (NFAs) (1) Merging the CBC with the government budget constraint (GBC) (assuming zero deficit). Disaggregating total consumption and canceling terms we obtain 3 NFAs and 6 real bilateral NFAs positions (6 variables, e.g. ). We deflate them and we get 2 independent NFAs equations and 3 real NFAs variables (net exports):

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17 NFAs (2) However, note that the risk premium in the UIP condition depends on NFAs positions between h and RoW and between U and RoW. Hence, we cancel intra-MU terms from both NFAs:

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18 Welfare maximizing monetary policy rules Two alternatives approaches are: 1.Ortega and Rebei (2006), who focus on unconditional welfare maximization, and 2.Levin et al. (2005) estimate an historical MP rule, but focus on a conditional welfare maximizing rule (conditional means that the model acts a restriction). The optimal MP rule is a function that depends on endogenous variables of the model and on the Lagrange multipliers.

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19 Unconditional approach Unconditional maximization implies using a grid search algorithm where the consumer i s utility is approximated by a second order Taylor expansion

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20 Simulations (1) 2 main structural asymmetries in our 3-country setting: (a) the economies differ in size (next slide):next slide home economy (NL) 2.6 % of the world, the RoEMU 38.07 %, RoW (US) accounts for 59.33 %. (b) Home economy + the Ro(E)MU create an MU, hence, they are asymmetric w.r.t. the RoW with own monetary policy. (c) additionally, we took into account more sclerotic characteristics of the European economy assuming that the RoW (the USA) features faster adjustment of prices and wages (lower prior means for Calvo parameters, 3rd column of table on slide 32).3rd column

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21 Simulations (2) back back n3-n2 n2-n1 n1

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22 Simulations (3) We perform simulations for the following cases: 1.Technological shock 2.Exchange rate shock (in the UIP condition) 3.Money demand shock 4.A preference shock to consumption (changing the willingness to work w.r.t. consumption). The latter shock is reported in the paper. in FT goods sector; in VT and VN goods sectors

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23 Simulations (5) Productivity enhancing shocks In particular, it is interesting that both monetary policies are expansionary (loosening) after positive technological shocks which increase outputs next slide. This happens because output increase is offset by deflation.next slide A similar behavior of central banks is noticed after a positive technological shock in intermediate goods sectors.

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24 Simulations (4). Worldwide and country-specific productivity enhancing shocks A positive technological shock hitting all the economies at the same time has a much stronger impact than similar country-specific technological shocks. backback

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25 Simulations (5) Positive technological shocks effects on control variables Shocks in FT sector Shocks in both VT and VN goods sectors

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26 Simulations (6) Exchange rate shock model with trade in intermediates vs. model without trade in intermediates With exchange rate shock ( depreciation), we demonstrate the influence of tradable intermediate goods modeling on the behavior of the model. To do that, we construct a very similar setting with: intermediate goods are all non-tradable and are used as inputs in the production process of the domestic country. Our simulations confirm the proposition of Dellas (2005), saying that the presence of intermediate goods can have important (negative) consequences for the ability of monetary authorities to manipulate nominal exchange rates (in our model via the UIP condition). (next slide)next slide Our model with tradable intermediate goods seems to be more stable after an exchange rate shock than the model with all non-tradable intermediate goods.

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27 Simulations (7) Exchange rate shock Model with trade in intermediates vs. Model without trade in intermediates back

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28 Simulations (8) Money demand shock (loosening) Comparison of 3 MP rules Overall, the response of all endogenous variables have a more volatile evolution when the committed rule smoothes the nominal interest rate (Rules (II) and (III)). Moreover, considering smoothing in the nominal interest rule, the one that includes wage inflation leads to lower deviations from the equilibrium after the shock. Therefore, Rule (III) stabilizes the economy more than Rule (II).

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29 Simulations (9) Shock to monetary policy (loosening) Comparison of 3 rules

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30 Estimation - data set The Netherlands (small open economy) vs. the Rest of the EMU and the US (big economies). We proximate the Rest of the Euro-zone by Euro12 minus the Netherlands. Data at 2000 prices from 1991 to 2005 (OECD Statistical Compendium) and from 1970 to 1990 it is backwardly completed with data from Eurostat. Hence, the quarterly sample runs from 1970 Q2 to 2005 Q4. We utilized Bayesian system estimation - see e.g. Smets and Wouters (2003) and Lubik and Schorfheide (2005).

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31 Estimations Rule II Results from Bayesian estimation back back NL RoEMU US Rule (II) estimated parameters Consumption parameters y NT yTyT StickinessStickiness

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32 Estimation Results For FT and FN goods, NL goods prices are sticky during 2.5 quarter, while in the US these are found to sticky during 1.5 quarter. Stickiness in V goods sectors is about one quarter less than in the final goods sectors and very similar among countries. It is less sticky in the NL than in the RoEMU. The same ordering as in the final goods sectors occurs w.r.t. wages. FT & FN VT & VN WT, WN, WVT & WVN NL 2.441.531.9 RoEMU 2.181.651.8 RoW 1.531.631.56

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33 Conclusions We construct a 3-country asymmetric NOEM model: detailed treatment of the consumption and production sectors. Comparing different specifications of CB MP rules, the simplest rule stabilizes more endogenous variables. FT, FNT, VT and VNT goods prices and also sectoral wages are assumed to be sticky. We find evidence that final goods present more stickiness. We find evidence that intermediate good markets are more competitive than final goods markets.

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