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Uncertain Potential Output and Simple Rules in Small Open Economy

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Abstract

This paper analyzes the implications of incomplete information for the conduct of monetary policy in small-open economy. I use a standard theoretical DSGE model to evaluate the performance of simple rules, including the exchange rate peg. Incomplete information is modeled assuming that the central bank and the private sector observe domestic inflation and output with a measurement error, while they do not observe potential output. I show that not reacting to the exchange rate yields better outcomes in terms of a standard loss function. For the case of complete information and incomplete information, I quantify for which parameter configuration a Taylor rule reacting to both the exchange rate and the domestic inflation rate yields a higher loss than the fixed exchange rate regime.

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Notes

  1. In open-economy models, uncertainty has been analyzed in a different way, such as deviation from the uncovered interest rate parity (Leitemo and Söderstrom 2005), and model uncertainty in a model calibrated on Australia data (Dennis et al. 2009).

  2. In the conduct of monetary policy, neither the component currencies, their assigned weights in the basket, nor the band limits are disclosed by the Monetary Authority of Singapore. Chow et al. (2014) examine the managed exchange rate system in Singapore using a DSGE vector autoregressive approach.

  3. This parameterization of policy coefficients ensures local uniqueness of the equilibrium.

  4. Since the analysis is theoretical, the estimation of shocks refers to the capacity of understanding which shock hits the economy and the size of the shock.

  5. Henceforth, all the matrices introduced will be known conformable matrices.

  6. These two matrices can be found numerically. Computational details, which follow the methodology described in Svensson and Woodford (2003), are available on request.

  7. Even in the case of zero-measurement error, the signal-extraction problem is relevant. The assumption of equal measurement error for domestic output and inflation is without loss of generality. The results do not vary qualitatively if I change the value for the measurement errors.

  8. The results do not vary qualitatively if I change the value for measurement errors.

  9. Benigno et al. (2007) prove this result analytically.

  10. The simulated model is a theoretical VAR according to the structure (7), enriched with the measurement equation (9) in the case of incomplete information. Therefore in the simulation the starting point is the steady state, which is shocked in order to analyze the on impact response and the transition back to the steady state.

  11. As noticed before, the shock to foreign output can be estimated using the \(\textit{IS}\) equation.

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Authors and Affiliations

  1. Università Europea di Roma, via degli Aldobrandeschi 190, 00163, Rome, Italy

    Guido Traficante

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  1. Guido Traficante
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Correspondence to Guido Traficante.

Additional information

This paper previously circulated with the title “Choosing the exchange rate system with incomplete information”. The very first version of the paper was written while I was visiting the department of economics at the University of California Santa Cruz. I am grateful for the department’s hospitality. I thank Daniel Beltran, Helde Berger, Giorgio Di Giorgio, Mathias Hoffmann, Federico Ravenna Abhijit Sen Gupta and Carl Walsh for their insightful comments. Any remaining errors are, of course, my sole responsibility.

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Traficante, G. Uncertain Potential Output and Simple Rules in Small Open Economy. Comput Econ 50, 517–531 (2017). https://doi.org/10.1007/s10614-016-9601-4

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