Published: 07.02.2011 Updated: 03.11.2011

Housing and banking in a small open economy DSGE model   (2.86 Mb)
Kristine Vitola, Viktors Ajevskis

The severe repercussions of the latest financial crisis highlighted the crucial role of the financial sector in the propagation of economic and financial shocks. In this paper we analyse the role of financial market frictions in business cycle fluctuations and in the transmission of monetary policy in a small open economy pursuing fixed exchange rate strategy. To this end, we develop and estimate a DSGE model for Latvia with financially constrained households and firms, embedding monopolistically competitive banking sector facing capital constraints. This general equilibrium framework is useful to study the potential of macro-prudential tools and their interaction with other macroeconomic and monetary policy instruments. Our findings suggest that the banking sector mutes the response of bank retail rates to an increase in the foreign policy rate and thus attenuates the drop in real aggregates. A permanent bank capital contraction subdues output, consumption, investment, domestic lending and foreign borrowing in the long run. Under a temporary shock to bank capital, asset prices and housing investment are first to recover, for loans it takes several years, while output, consumption and capital investment rebound at a slower pace. In the long run, a tighter capital requirement leads to higher output, capital investment and domestic lending while reducing household deposits and foreign liabilities of banks.


Keywords: DSGE models, Bayesian estimation, banks, financial frictions, macro-financial linkages, small open economy
JEL classification: C11, C32, E43, E44, F41, R21

Fixed Exchange Rate Versus Inflation Targeting: Evidence from DSGE Modelling   (2.61 Mb)
Kristine Vitola, Viktors Ajevskis

We evaluate implications of inflation targeting versus fixed exchange rate regime for the UK, Sweden, Poland, the Czech Republic, Estonia, Latvia and Lithuania, i.e. seven EU non-euro area countries. To this end, we estimate a small open economy DSGE model and simulate a model under estimated structural parameters and different sets of policy parameters. The results obtained are compared in terms of inflation, output gap and interest rate volatility. For inflation targeting countries, a policy switch to fixed exchange rate would entail 3–6 times higher inflation volatility. In the Baltic economies, a policy change to inflation targeting with fully flexible exchange rate would amplify inflation volatility 2–4 times, whereas the existing price stabilisation and exchange rate fluctuations within the ERM II bands would entail 3–6 times more volatile inflation. Policy simulations thus show evidence that in all the countries the existing monetary rule guarantees more stable inflation and output than under alternative regimes.

Keywords: DSGE, small open economy, fixed exchange rate, inflation targeting, Bayesian estimation
JEL classification: C11, C3, C51, D58, E58, F41
2011/1 Price Setting Behaviour in Latvia: Econometric Evidence from CPI Micro Data   (977.68 Kb)
Konstantins Benkovskis, Ludmila Fadejeva, Krista Kalnberzina

This paper discovers the driving forces behind firms' decisions to adjust prices by using various panel logit models, which explain the probability of observing price change by a broad set of exogenous variables. The results of the models show that the consumer price formation in Latvia is a combination of both state-dependent and time-dependent behaviour. On the one hand, frequency of price changes depends on inflation, demand conditions, and the size of last price changes. On the other hand, we observe some elements of time-dependent price setting, e.g. price truncation and strong seasonal pattern. We also find several important differences in the price setting behaviour for cases of price increases and decreases. The fact that frequency of price changes in Latvia depends on inflation as well as demand and supply conditions could be seen as a prerequisite for faster price adjustment process in the event of distortions in the economy. In the case of economic imbalances, state-dependent price formation changes flexibility of prices and ensures a faster adjustment process towards equilibrium.

Keywords: price setting behaviour, Latvia's consumer prices, frequency of price change, sales, time-dependent pricing, state-dependent pricing, panel logit model 
JEL classification: C23, D40, E31