There is no single model that will serve best for all central bank purposes. NEMO (Norwegian Economy Model) is a core model supported by surrounding satellite models which serve certain tasks. Since Norges Bank is an inflation targeting central bank, expectations and the lags with which the monetary policy affects the economy should be paid particular attention, Norges Bank (2006). This is reflected in NEMO, which is a modern DSGE (Dynamic Stochastic General Equilibrium) model, based on the International Monetary Fund’s multicountry Global Economic Model (GEM). NEMO is a smaller and simpler model than the GEM, but also modified to better fit the Norwegian economy. NEMO is a two country model, microeconomic founded and builds on the New Keynesian framework, cf. Norges Bank (2006).
The purpose of this thesis is to develop a flexible prices version of NEMO. This is a completely theoretical thesis and it will not give any empirical results.
There are various reasons for why we should care about a flexible price solution of NEMO. The thesis focuses on the natural level of production. Woodford (2003) argues that flexible price models should serve as a benchmark for measuring the natural rate of output and the output gap. "The level of output that would occur in an equilibrium with flexible prices, given current real factors (tastes, technology, government purchases) -what is called the "natural rate" of output, following Friedman (1968)-turns out to be a highly useful concept..." Woodford (2003, pp.8). Woodford mentions further that Wicksell (1898) discusses "the natural rate of interest", which is the real rate of interest that would be realized in an equilibrium with flexible prices.
"Natural" levels of macroeconomic variables are of highly importance for central banks. Natural level of production and the output gap, which is defined as the gap between the natural level of production and actual production, are both of high importance in monetary theory, Walsh (2003). The output gap is an indicator for economic pressure and also enters in a central bank’s loss function.
The DSGE framework opens for calculations of the natural levels, according to Woodfords definition. This relates the natural level of production to the real shocks in the economy. This will give us a more volatile natural level of output in proportion to other ways of extracting natural levels of production e.g. Hodrick-Prescott filtering. On the other hand, as Neiss, K. S. and Nelson, E. (2005) state, the output gap is no longer a measure of the business cycle. The outputgap is solely related to the nominal rigidities.
In addition to the removal of nominal rigidities, the flexible price model is modified from local currency pricing in NEMO, to producer currency pricing. This is done because it is assumed that domestic households are better off in a model where domestic prices are flexible and prices abroad are sticky, than in a model where all prices are flexible. This assumption is debatable. It is not clear whether prices abroad should be flexible or not. As long as flexible home prices and sticky prices abroad are assumed, then producer currency pricing is needed to avoid monetary policy to have an effect on the real economy.
The flexible price model of NEMO which is developed in this thesis consists of a system of 47 non linear equations and 47 endogenous variables. This include 16 shock processes, where 5 shocks are due to the exogenous foreign country, 4 shocks are preference shocks, 4 are markup shocks, 2 are technology shocks and 1 is public spending shock.