Modelling a Small Open Economy Using a Wavelet-Based Control Model

Abstract

This paper develops a wavelet-based control system model that can be used to simulate fiscal and monetary strategies in an open economy context in the timefrequency domain. As the emphasis on real exchange rate stability is increased, the model simulates the effects on both the aggregate and decomposed trade balance under both constant and depreciating real exchange rate targets, and also the effects on the real GDP expenditure components. This paper adds to recent research in this area by incorporating an external sector via the use of a real effective exchange rate as a driver of output. The research is also the first to analyze exchange rate effects within a time-frequency model with integrated fiscal and monetary policies in an open-economy applied wavelet-based optimal control setting. To demonstrate the usefulness of this model, we use post-apartheid South African macro data under a political targeting design for the frequency range weights, where we simulate jointly optimal fiscal and monetary policy under varying preferences for real exchange rate stability.