An Estimated DSGE Model for Norway: Does Norges Bank React to the Changes in the Nominal Exchange Rate?

Abstract

During the past decade about 30 countries have adopted inflation target as their monetary policy framework, letting their currencies to float more or less freely. Such a switch can lead to volatile exchange-rate fluctuations, which can have a negative effect on economic welfare. Excessive exchange-rate fluctuations may also cause macroeconomic instability. A question can be raised whether inflation-targeting central banks should respond to exchange-rate movements.

In this master thesis, we model a small open economy with the objective to estimate a simple interest rate rule for the Norwegian economy. The model consists of four equations and four shocks. We are specially interested in whether the changes in the nominal exchange rate are given systematic weight in the reaction of Norges Bank. We do so by exploiting Bayesian estimation in MatLab (Dynare routine). We choose priors for the parameters and study the resulting posteriors. We find that Norges Bank has in fact reacted to the exchange rate movements. We also discuss that this result does not necessarily means that the exchange rate enters directly in the monetary function but rather reflects the fact that Norges Bank uses information provided by the exchange rate movements in its assessment of the inflation development in the medium term.

As the next step, we use Dynare to estimate optimal parameters of the same interest rule with the same data and the same model to see whether it would be optimal for Norges Bank to actually react to exchange rate movements. We find that it may be optimal for Norges Bank to react to exchange rate movements, but the optimal value is lower than the estimated one. We explain this by the fact that the optimal rule is estimated for the full-information case while Norges Bank operates in an imperfect information environment and thus may put more weight on information parameters than in the full information case.

The structure of the thesis is the following: chapter 1 gives an introduction to the topic. We discuss the importance of the exchange rate channel in modeling a small open economy. We present an overview of the "new open economy" modeling development during the recent decade. This "new open-economy macroeconomics" is a synthesis of real business cycle theory and Keynesian elements such as nominal rigidities and imperfect competition. We present three typical articles that focus on whether inflation-targeting central banks should react to exchange rate movements. We conclude that the authors agree on the essential point, namely that the exchange rate may provide useful information about the inflation development in the medium term. We go on by discussing the assumptions of the model. We derive the Dynamic IS-curve and Phillips curve, as well as evolution equation for exchange rate and a monetary policy rule. We discuss shortly possible extensions of the model. In chapter 2 we estimate the model. We describe the method of Bayesian estimation which involves confronting the data with our beliefs about the parameters of the economy. We describe the data, explain the priors and summarize the results. Finally, we estimate a simple optimal policy rule and discuss our findings.