A Small Open Economy DSGE Model for Pakistan

Abstract

This paper estimates a small open economy Dynamic Stochastic General Equilibrium (DSGE) model for Pakistan using Bayesian simulation approach. Model setup is based on new Keynesian framework, characterised by nominal rigidity in prices with habit formation in household’s consumption. The core objective is to study whether an estimated small open economy DSGE model provides a realistic behavior about the structure Pakistan economy with fully articulated description of the monetary policy transmission mechanism vis -à-vis domestic firm’s price setting behavior. To do so, we analyse the impulse responses of key macro variables; domestic inflation, imported inflation, output, consumption, interest rate, exchange rate, term of trade to different structural/exogenous shocks. From several interesting results, few are; (a) high inflation in Pakistan do not hit domestic consumption significantly; (b) Central bank of Pakistan responds to high inflation by increasing the policy rate by 100 to 200 bps; (c) exchange rate appreciates in both the cases of high domestic and imported inflation; (d) tight monetary policy stance helps to curb domestic inflation as well as imported inflation but appreciates exchange rate significantly (f) pass through of exchange rate to domestic inflation is very low; finally parameter value of domestic price stickiness shows that around 24 percent domestic firms do not re-optimise their prices which implies averaged price contract is about two quarters.New-Keynesian Economics, Open Economy DSGE Models, Nominal Rigidities, Monetary Policy, Transmission Mechanism, Bayesian Approach