A Small Open Economy DSGE Model for Pakistan

Abstract

In recent years there has been a growing interest in academics, international policy institutions and central banks1 in developing small-to-medium, even large-scale, open economy macroeconomic models called Dynamic Stochastic General Equilibrium (DSGE) models based on new-Keynesian framework.2 The term DSGE was originally used by Kydland and Prescott (1982) in their seminal contribution on Real Business Cycle (RBC) model. The RBC model is based on neoclassical framework with micro-founded optimisation behaviour of economic agents with flexible prices. One of the critical assumptions of this model is that fluctuations of real quantities are caused by real shock only; that is, only stochastic technology or government spending shocks play their role. Later research in DSGE models however included Keynesian short-run macroeconomic features (called nominal rigidities), such as Calvo (1983) type staggered pricing behaviour and Taylor (1980) type wage contracts. Hence this new DSGE modeling framework labeled as new-neoclassical synthesis or new-Keynesian modeling paradigm. 3 This new approach combines micro-foundations of both households and firms optimisation problems and with a large collection of both nominal and real (price/wage) rigidities that provide plausible short-run dynamic macroeconomic fluctuations with a fully articulated description of the monetary policy transmission mechanism; see, for instance, Christiano, et al. (2005) and Smets and Wouters (2003). The key advantage of modern DSGE models, over traditional reduce form macroeconomic models, is that the structural interpretation of their parameters allows to overcome the famous Lucas critique (1976).4 Traditional models contained equations linking variables of interest of explanatory factors such as economic policy variables. One of the uses of these models was therefore to examine how a change in economic policy affected these variables of interest, other things being equal. In using DSGE models for practical purposes and to recommend how central banks and policy institutions should react to the short-run fluctuations, it is necessary to first examine the possible sources,5 as well as to evaluate the degree of nominal and real rigidities present in the economy. In advanced economies, like US and EURO area, it is easy to determine the degree of nominal and real rigidities as these economies are fully documented. In developing economies like Pakistan, where most of economic activities are un-documented (also labeled as informal economy, black economy, or underground economy), it is very difficult to determine the exact degree of nominal and real rigidities present in the economy. However, one can approximate results using own judgments and through well defined survey based methods

Finance-Growth Nexus and Relative Efficacy of Alternative Policy Regimes: An Investigation for Pakistan

“…For instance, Malik and Ahmed (2010) argued that monetary policy in Pakistan is highly accommodative as weights on inflation (0.32) and output (0.19) in monetary policy rule diverge considerably from what have been proposed by Taylor. Nevertheless, Haider and Khan (2008) in context of DSGE model showed that estimated coefficients (1.17 and 0.72) are closer to what conjectured by Taylor rule. The estimated coefficients of present study may be considered as an average with slightly accommodative monetary policy towards inflationary pressures while pursuing growth objective steadfastly.…”

On the (Ir)Relevance of Monetary Aggregate Targeting in Pakistan: An Eclectic View

“…The parameter value of the discount factor () is set in order to obtain the historical mean of the nominal interest rate in the steady state. Following Haider and Khan (2008), the degree of price stickiness () is assumed to be 0.74. This value is consistent with the latest survey-based finding on firms' optimal pricing behavior in Pakistan (see Choudhary, Naeem, Faheem, Hanif, & Pasha, 2011).…”

New Keynesian Macroeconomic Model and Monetary Policy in Pakistan

“…In essence, the requirement is to develop a structural model which is free from such criticism and could be useful for policy analysis. Before we start discussing the model it is important to acknowledge the work of Haider andKhan (2008) andAhmed, et al (2012) that have worked on the structure of DSGE model. Both these studies have, however, 'managed' the unavailability of microeconomic parametric values by relying on 'borrowed' values from the countries other than Pakistan.…”