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A Welare Evaluation o East Asian MonetaryPolicy Regimes under Foreign Output Shock
Joseph D. Alba, Wai-Mun Chia, and Donghyun Park
No. 299 | February 2012
ADB EconomicsWorking Paper Series
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ADB Economics Working Paper Series No. 299
A Welare Evaluation o East Asian Monetary
Policy Regimes under Foreign Output Shock
Joseph D. Alba, Wai-Mun Chia, and Donghyun Park
February 2012
oseph . Alba is Associate rofessor, ivision of conomics, chool of umanities and ocial ciences,
anyang echnological niversity, ingapore. ai-Mun Chia is Assistant rofessor, ivision of conomics,
chool of umanities and ocial ciences, anyang echnological niversity. onghyun ark is rincipal
conomist, Macroeconomics and inance esearch ivision, conomics and esearch epartment,Asian evelopment Bank.
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Asian evelopment Bank
AB Avenue, Mandaluyong City
1550 Metro Manila, hilippines
www.adb.org/economics
2012 by Asian evelopment Bankebruary 2012
155-5252
ublication tock o. 1245
he views expressed in this paper
are those of the authors) and do not
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of the Asian evelopment Bank.
he AB conomics orking aper eries is a forum for stimulating discussion and
eliciting feedback on ongoing and recently completed research and policy studies
undertaken by the Asian evelopment Bank AB) staff, consultants, or resource
persons. he series deals with key economic and development problems, particularly
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methodological issues relating to project/program economic analysis, and statistical data
and measurement. he series aims to enhance the knowledge on Asias development
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availability of statistical data and development indicators for monitoring development
effectiveness.
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journals or chapters in books. he series is maintained by the conomics and esearch
epartment.
Printed on recycled paper
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Contents
Abstract v
. ntroduction 1
. ole of Monetary and xchange ate olicies
in Cushioning xternal hocks 4
. he Model 5
A. ouseholds 5
B. omestic irms
C. rice evel, erms of rade, and eal xchange ate 8
. Monetary olicy and xchange ate egimes 9
. elfare 9
. Model arameterization 10
. imulation esults and elfare 11
A. mpulse esponses under arious Monetary olicy egimes 11
B. elfare osses under arious Monetary olicies 1
C. ummary of imulation esults and elfare 19
. Conclusions 20
eferences 22
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Abstract
Adverse foreign output shocks have a sizable impact on the welfare of small
open economies. herefore, one of the key roles of monetary policy in those
economies is to minimize the welfare losses arising from such shocks. o
assess the welfare impact of external shocks under different monetary policy
regimes, we numerically solve and calculate the welfare loss function of a
G\QDPLFVWRFKDVWLFJHQHUDOHTXLOLEULXPPRGHOZLWKFRPSOHWHH[FKDQJHUDWHSDVV
WKURXJK:HQGWKDWFRQVXPHUSULFHLQGH[&3LQDWLRQWDUJHWLQJPLQLPL]HV
welfare losses for import-to-gross domestic product ) ratios from 0. to 0.9.
+RZHYHUZHOIDUHXQGHUWKHSHJJHGH[FKDQJHUDWHUHJLPHLVDOPRVWHTXLYDOHQWWR&3LQDWLRQWDUJHWLQJZKHQWKHLPSRUWWR*'3UDWLRLVZKLOHWKHGRPHVWLF
LQDWLRQWDUJHWLQJPLQLPL]HVZHOIDUHZKHQWKHLPSRUWWR*'3UDWLRLV:H
calibrate the model and derive welfare implications for eight ast Asian small
open economies.
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I. Introduction
Adverse foreign output shocks have a sizable impact on the macroeconomic performance
of small open economies. or example, the sharp recession of the advanced economies
GXHWRWKHJOREDOQDQFLDODQGHFRQRPLFFULVLVRIKDGDSURQRXQFHGHIIHFWRQ
the export and growth of ast Asias highly open, export-dependent economies. able 1
shows the cumulative contraction in real gross domestic product ) growth, relative
WRWUHQGRIWRIRU6LQJDSRUH7DLSHL&KLQDDQG+RQJRQJ&KLQDRU
WKHHSXEOLFRIRUHDDOD\VLDWKH3KLOLSSLQHVDQG7KDLODQGLWZDVWR
7DEOHFRQUPVWKDWWKHSULPDU\FKDQQHOIRUWKHWUDQVPLVVLRQRIWKHJOREDOFULVLVWR(DVW
Asia was the trade channel. he cumulative contraction of real export growth ranged
from 5.9 for ndonesia to 8.8 for hailand. t is not surprising that exports have
a large impact on the real of ast Asian economies in light of their heavy export
GHSHQGHQFH7KHUDWLRRIH[SRUWVWR*'3HYHQH[FHHGVLQ+RQJRQJ&KLQD
DOD\VLDDQG6LQJDSRUH
n light of their large effect on the macroeconomic outcomes of small open economies,
we can expect adverse foreign output shocks to have a large effect on their welfare.
herefore, one of the key roles of monetary policy in those economies is to minimize
the welfare losses arising from such shocks. able 1 shows the various monetary and
H[FKDQJHUDWHSROLF\UHJLPHVDGRSWHGE\(DVW$VLDQHFRQRPLHV+RQJRQJ&KLQDDQG
6LQJDSRUHKDYH[HGDQGSHJJHGH[FKDQJHUDWHUHJLPHVUHVSHFWLYHO\ZKLOHWKHHSXEOLF
RIRUHDQGRQHVLDWKH3KLOLSSLQHVDQG7KDLODQGKDYHDGRSWHGLQDWLRQWDUJHWLQJ
policies. Malaysia and aipei,China aim to do both, i.e., stabilize prices and intervene in
WKHIRUHLJQH[FKDQJHUDWHPDUNHWV(FRQRPLHVWKDWWDUJHWH[FKDQJHUDWHV+RQJRQJ
&KLQD6LQJDSRUHDQG7DLSHL&KLQDVKRZHGORZHUDYHUDJHFKDQJHVLQH[FKDQJHUDWHV
WKDQFRXQWULHVWKDWWDUJHWLQDWLRQQGRQHVLDWKHHSXEOLFRIRUHDWKH3KLOLSSLQHV
and hailand.1 he exception is Malaysia, which target both variables but experienced
DQDYHUDJHFKDQJHLQH[FKDQJHUDWHFORVHUWRLQDWLRQWDUJHWLQJFRXQWULHVQDGGLWLRQ
economies that target the exchange rate suffered a visibly larger cumulative decline in
UHDO*'3FRPSDUHGWRHFRQRPLHVWKDWWDUJHWLQDWLRQQDWLRQKDVEHHQJHQHUDOO\ORZIRU
all economies regardless of policy regimes.
2
1 Hong Kong, China; Singapore; and Taipei,China experienced the smallest average percentage change in exchangerates o 0.42%, 3.01%, and 3.98%, respectively. In contrast, Indonesia, the Republic o Korea, the Philippines, andThailand experienced an average percentage change in exchange rates in the range o 6.92% to 27.16%. Malaysia,which targets both exchange rate and ination but experienced an average change in exchange rate o 6.90%,which is closer to ination-targeting countries, is an exception.
2 In act, Indonesia and Thailand experienced deation.
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he central objective of this paper is to evaluate and compare the welfare impact of
H[WHUQDOVKRFNVXQGHUGLIIHUHQWPRQHWDU\DQGSROLF\UHJLPHVRUHVSHFLFDOO\ZHORRNDW
the welfare effects of foreign output shocks under seven different types of monetary and
H[FKDQJHUDWHSROLF\UHJLPHVD[HGRUSHJJHGH[FKDQJHUDWHUXOHDFRQVXPHUSULFH
LQGH[&3LQDWLRQWDUJHWLQJUXOHLQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJUXOHGRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDORXWSXWWDUJHWLQJDQGUHDORXWSXWWDUJHWLQJ
:HGRVRIRUHLJKWVPDOORSHQHFRQRPLHVLQ(DVW$VLD+RQJRQJ&KLQDQGRQHVLD
WKHHSXEOLFRIRUHDDOD\VLDWKH3KLOLSSLQHV6LQJDSRUH7DLSHL&KLQDDQG7KDLODQG
to assess and compare the extent to which each monetary and exchange rate policy
regime protects each of the eight economies from external shocks. ur welfare evaluation
is based on numerically solving and calculating the welfare loss function of a dynamic
VWRFKDVWLFJHQHUDOHTXLOLEULXP'6*(PRGHO:HFDOLEUDWHWKHPRGHOWRGHULYHZHOIDUH
implications for the eight countries.
ur paper is broadly similar with Alba, u, and Chia 2011) in its methodology. More
precisely, the two papers both use a model that is broadly based on Monacellis 2004) model of a small open economy. owever, Alba, u, and Chia 2011) examine the
impact of a negative foreign output shock on the volatility of macroeconomic variables
under alternative monetary and exchange rate policy regimes while we examine the
more fundamental, policy-relevant issue of the impact of such a shock on welfare. hile
macroeconomic volatility is important, it is a much less complete yardstick for evaluating
policy regimes than welfare. urthermore, the analysis of Alba, u, and Chia 2011) is
OLPLWHGWRWKUHHSROLF\UHJLPHVDQGIRXUFRXQWULHV7KHLUPDLQQGLQJLVWKDWVPDOORSHQ
HFRQRPLHVWKDWIROORZHLWKHU[HGH[FKDQJHUDWHRULQDWLRQWDUJHWLQJWHQGWRVWDELOL]H
UHDOH[FKDQJHUDWHDQGLQDWLRQEXWDWWKHH[SHQVHRIVXEVWDQWLDOYRODWLOLW\LQWKHUHDO
economy.
ur paper evaluates and compares the welfare losses of foreign output shocks under
alternative monetary and exchange rate policy regimes, and is thus able to inform us
about the relative desirability of different policy regimes. uch a welfare comparison is
useful for determining the optimal monetary and exchange rate policy regime in ast
Asias small open economies that are highly dependent on trade and hence vulnerable
WRIRUHLJQRXWSXWVKRFNV7KHSURQRXQFHGLPSDFWRIWKHUHFHVVLRQLQWKH
DGYDQFHGHFRQRPLHVLVDYLYLGUHPLQGHURIWKLVYXOQHUDELOLW\7KHFHQWUDOTXHVWLRQZH
seek to answer is the following which monetary and exchange rate policy regime leaves
ast Asian small open economies best off under external shocks? he rest of this paper
is organized as follows. ection explores the relationship between monetary and
H[FKDQJHUDWHSROLF\UHJLPHVDQGPDFURHFRQRPLFSHUIRUPDQFH6HFWLRQVSHFLHVRXUmodel. ection reports and discusses the main results, and ection concludes the
paper.
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II. Role o Monetary and Exchange Rate Policies
in Cushioning External Shocks
he current crisis calls for a re-examination of macroeconomic policies in general andPRQHWDU\DQGH[FKDQJHUDWHSROLFLHVLQSDUWLFXODU6WLJOLW]DUJXHVWKDWLQDWLRQ
targeting is inappropriate, especially for emerging economies where energy and
commodities make up a larger share of the household budget compared to industrialized
countries. ther economists have suggested alternative monetary policy targets such as
nominal . n addition, Blanchard, ellAriccia, and Mauro 2010) argue that there
PD\EHDFDVHIRUWKHHPHUJLQJPDUNHWFHQWUDOEDQNHUVSUDFWLFHRIWDUJHWLQJLQDWLRQ
ZKLOHDOVRLQWHUYHQLQJLQWKHIRUHLJQH[FKDQJHPDUNHWV'HVSLWHWKHFULWLFLVPRILQDWLRQ
WDUJHWLQJGH&DOYDOKRLOKRQGVWKDWLQDWLRQWDUJHWLQJFRXQWULHVRXWSHUIRUPHG
QRQLQDWLRQWDUJHWLQJFRXQWULHVLQWKHSRVWSHULRG+HDUJXHVWKDWGXULQJWKHFULVLV
LQDWLRQWDUJHWLQJFRXQWULHVORZHUHGQRPLQDOLQWHUHVWUDWHVE\PRUHUHVXOWLQJLQHYHQ
larger real interest rate differentials and thus an even stronger monetary stimulus.
he theoretical and empirical literature also suggest a number of rationales for why
different monetary and exchange rate policy regimes may differ in their capacity to protect
FRXQWULHVIURPH[WHUQDOVKRFNVRUH[DPSOHLWLVRIWHQDUJXHGWKDWFRXQWULHVZLWKH[LEOH
exchange rate regimes can better insulate their economies from negative real shocks.4
n a study that is highly relevant to the transmission of foreign output shocks to ast Asia
GXULQJWKHFULVLV+RIIPDQQXVHVGDWDIURPDVDPSOHRIGHYHORSLQJ
FRXQWULHVWRWHVWWKHK\SRWKHVLVWKDWH[LEOHH[FKDQJHUDWHVVHUYHDVDVKRFNDEVRUEHU
in small open economies, and mitigate the impact of external shocks more effectively
WKDQ[HGH[FKDQJHUDWHUHJLPHV+RIIPDQQGVWKDWFRXQWULHVZLWKPRUHH[LEOH
nominal exchange rates suffer smaller decline of real . his is due to real exchangerate depreciation, which improves external competitiveness and thus partly offsets the
negative impact of foreign output shocks.
n this paper, we evaluate and compare the welfare loss due to foreign output shocks in
ast Asias small open economies under alternative monetary and exchange rate policy
regimes. o do so, we develop a simple model that contains a goods market
characterized by imperfect competition and nominal rigidities.5 e numerically solve and
calculate the welfare loss function of the model under seven types of monetary
DQGH[FKDQJHUDWHSROLF\UHJLPHVD[HGRUSHJJHGH[FKDQJHUDWHUXOHD&3LQDWLRQ
WDUJHWLQJUXOHLQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJUXOHGRPHVWLFLQDWLRQWDUJHWLQJ
3 A debate on nominal GDP targeting among economists could be accessed online at http://economistsview.typepad.com/economistsview/2010/12/bernanke-and-mishkin-on-nominal-gdp-growth-targeting.html
4 Please reer to Friedman (1953), Mundell (1961), Poole (1970), Dornbusch (1980), Luer (1994), Obsteld andRogof (2000), Devereux (2004), Devereux, Lane, and Xu (2006), Broda (2004), Edwards and Levy Yeyati (2005), andHofman (2007).
5 There is a large and growing literature on open economy DSGE models that incorporate imperect competitionand nominal rigidities. Obsteld and Rogof (1995 and 1996) initiated open-economy macroeconomics researchbased on a synthesis o dynamic intertemporal approaches and sticky-price models o macroeconomicuctuations. This synthesis is known as the new open economy macroeconomics. Many economists have relied onthis new class o models to address many classical problems with new tools, and to generate new research ideasand questions.
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aylor-type rule, nominal output targeting, and real output targeting. he open economy
framework makes it possible to examine the exchange rate channel in the transmission of
foreign output shocks to the domestic economy. e assume foreign output shocks to be
exogenous.
DQ\'6*(PRGHOVFRQVLGHURQO\WZRIDFWRULQSXWVQFRQWUDVWZHIROORZLPDQG
oungani 1992) and assume oil to be an input in a constant elasticity of substitution
C) production function where oil and capital are substitutes. ence, our model
captures an important stylized fact of global energy use, i.e., more developed economies
use less energy per unit of capital than less developed economies. n addition, it is
possible that exchange rate depreciation affects the price of imported oil which, in turn,
affects domestic output. e follow Monacelli 2004) and assume that capital is subject
to adjustment costs. ach monetary and exchange rate policy regime implicitly assigns
GLIIHUHQWZHLJKWVRQRYHUDOOLQDWLRQGRPHVWLFLQDWLRQWKHRXWSXWJDSDQGH[FKDQJHUDWH
in the interest rate rule. By explicitly evaluating and comparing the welfare loss due to
foreign output shocks under different types of monetary policy regimes, we address theextent to which different policy regimes mitigate the loss of welfare.
III. The Model
n this section, we lay out our model, which is broadly based on Monacellis 2004)
PRGHORIDVPDOORSHQHFRQRP\GHQWLFDODQGLQQLWHO\OLYHGKRXVHKROGVHDUQLQFRPH
IURPZRUNLQJIRUDQGUHQWLQJSK\VLFDOFDSLWDOWRGRPHVWLFUPV7KH\FRQVXPHEDVNHWVRI
differentiated domestic and foreign tradable goods.
A. Households
he domestic economy is populated by a continuum RILQQLWHO\OLYHGLGHQWLFDO
households. hey consume baskets of differentiated domestic and foreign goods that
are both tradable and indexed byj. he baskets of domestic and foreign varieties
of goods are associated with utility-based price indices P P j dj H t H t , , ( )( )
1
0
1 11--
and
P P j dj F t F t , , ( )( )
1
0
1 11--
, respectively, where the His the index for home and Ffor
foreign. he price indices are expressed in units of domestic currency.P jH t, ( ) and
P jF t, ( ) are prices of the individual domestic and foreign good j, respectively, where - ! 1is the elasticity of substitution between varieties within each category. he utility-based
consumer price index is given by P P Pt H t F t = + ( )( )
, ,
/1 1
1 1
1 .
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n each period, the households optimally allocate their expenditure on differentiated goods
within each category. he demand functions are
C jP j
PC C j
P j
PH t
H t
H t
H t F t
F t
F t
,
,
,
, ,
,
,
) )
; ) )
=
=
-
-
CF t, 1)
for alljgoods within the interval of 0 and 1, where the goods are produced
E\DFRQWLQXXPRIUPVDQGWKHUPVDUHRZQHGE\GRPHVWLFKRXVHKROGV
C C j dj H t H t , , ( )( )
- -
- -1
0
1 1
and C C j dj F t F t , , ( )( )
- -
- -1
0
11
are composite indices of
domestic and foreign goods, respectively. he households consume a C composite of
both home products CH) and foreign products CF)
C C Ct H t F t = + ( )( )
1 1 1 1
1
1, , 2)
where J0,1 is the share of home-produced goodsLQWRWDOFRQVXPSWLRQVRJrepresents the share of foreign-produced goods. U>1 is the elasticity of substitution
between domestic and foreign goods. nvestment composite index In In Int H t F t , ,,( ) hasan identical expression as consumption for simplicity. he optimal allocation of any
given expenditure between domestic and foreign goods yields the consumption demand
CP
PC C
P
PCH t
H t
t
t F t
F t
t
t,
,
,
,; )=
=
1
.
he representative domestic household maximizes the utility function over time
EC N
t t t t
t
1 1
0 1 1
+
=
+
)where V > 0 and M > 0, E is the discount factor and E ( )0 1, . 1/V is the intertemporalelasticity of substitution and M is the elasticity of labor substitution. Et is the expectation
operator. Ct is the consumption and Nt is the labor supply of the representative household
at time t.
he representative household holds securities denominated in domestic currency, rents
RXWLWVFDSLWDOWRWKHKRPHEDVHGPRQRSROLVWLFFRPSHWLWLYHUPDQGGHULYHVLQFRPHIURP
working for each time t. ence, the households budget constraint is written as
P C In B W N Z K Bt t t t t h
t t t t t t t
t
+( ) + ( ) = + + ++ ++ , 1 11 4)
where Bt1 is the portfolio of state contingent securities household holds at the end of
t, Qt t, 1 LVGHQHGE\RQDFHOOLDVWKHSULFLQJNHUQHORIVWDWHFRQWLQJHQWSRUWIROLR
HTXDOWRQ = + )h ht t1 where Monacelli lets h h ht t ,...., )0 be the history of events up toperiod tand the date 0 probability of observing htLVGHQHGDVdtwhere at the initial
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state d h )0 1 RQDFHOOLGHQHVWKHH[SHFWDWLRQRSHUDWRU E d h ht ht t
t
. ){} +
+1
1
. Wtis
the nominal wage, Zt is the nominal rental cost, and Wt represents the lump-sum transfer
payment.
ollowing Monacelli, capital accumulation is described as
K KIn
KKt t
t
t
t+ = ( ) +
1 1 G 5)
where G is the physical depreciation rate of capital. ) is an increasing and concave
function that assumes the adjustment cost in capital accumulation. ence, Intunits of
investment translate into In K K t t t( ) units of additional capital.
ith the arbitrage condition holding, it implies that
11
1Rt
t tht
= ++
Q ,and
11
1
1Rt
t th
t
tt
,= +
+
+
given that Rt and Rt
are expected returns in terms of domestic and foreign currency on
the bond portfolio.RQDFHOOLHTXDOL]HVWKHVHUHWXUQVWRJHW
t t t t t
thR R
t
, + + =+ 1
1
1
0
he rest of the world is assumed to have foreign households with similar preferences
as the home country so that foreign demand for home produced goodjis
C jP j
PC
P j
PH t
H t
H t
H t
H t
H t
,
,
,
,
,
,
( ) =( )
=
( )
- --
CH t,
where CP
PCH t
H t
t
t,
,
= ( )
1
.
B. Domestic Firms
abor, capital, and oil are inputs to production described by the constant elasticity of
substitution C production function. il is included in the C function following Alba,
u, and Chia 2011).7KHUHLVDFRQWLQXXPRIPRQRSROLVWLFDOO\FRPSHWLWLYHUPVZKLFK
are indexed by j[ ]0 1, . he C production function with constant return to scale hasWKHIROORZLQJVSHFLFDWLRQ
Y j A K j O j N j t t t t t ( ) = ( ) + ( ) ( ) ( ) ( )
1 1
1 1
1 )/
)
where 0 1 D , L ! 0 and X ! 0 . he elasticity of substitution between capital andRLOLVHTXDOWR 1/Q while labor share in production is given by D.
6 Rt = 1 + it where it is the nominal interest rate.7 For details, please reer to Alba, Su, and Chia (2011). Similarly, Backus and Crucini (2000) and Kim and Loungani
(1992) nest capital and oil as a CES unction within a Cobb-Douglas production unction while Rotemberg andWoodord (1996) and Blanchard and Gali (2007) consider oil and labor as inputs to production. Alternatively, Finn(2000) assumes oil and capital as complimentary. The complemetarity or substitutability o oil and capital areunresolved in empirical literature. For a survey o the literature, please reer to Apostolakis (1990). In addition,Bodenstein, Erceg, and Guerrieri (2008) consider oil as part o household consumption while Aoki (2001) examinesthe relationship between sector-specic supply shocks such as oil price shocks and ination uctuations.
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Monacelli 2004) follows Calvos 198) pricing. A fraction 1Ip RIDOOUPVDGXVWVWKHLUSULFHVUDQGRPO\ZKLOHWKHUHVWRIWKHUPVIp, do not adjust their prices. he parameter
Ip represents the degree of nominal rigidity whereby a largerIp LPSOLHVIHZHUUPV
adjusting their prices, causing a longer expected time between price adjustments. irms
IXWXUHSURWVDW t+kare affected by the choice of price at time tRQO\LIWKHUPGRHVQRWget another opportunity to adjust its price between tand t+k. Ip
k
LVWKHSUREDELOLW\RIDUP
not adjusting its price from tto t+k7KHGRPHVWLFUPjwill set price PH tNew
, to maximize the
SURWIXQFWLRQ
E P j MC j Y j tk
p
k
t t k H t
new
t kk
t k , ,+ +
=
+( ) ( ) ( )
0
)
subject to the domestic and foreign demand given byY jP j
PC Ct k
H t
new
H t k
H t k H t k ++
+ +( )
( )
+
,
,
, ,
-
where t t k, + LVWKHWLPHYDU\LQJSRUWLRQRIWKHUPVGLVFRXQWIDFWRU+HQFHWKHRSWLPDOpricing condition is
P j
E MC j Y j
H t
new
t
k
p
k
t t k t k t k k
,
,
( ) =
( ) ( )
+ + +
=
1
0
( )
+ +=
E Y jt k pk t t k t k k
,0
8)
7KHDERYHHTXDWLRQGHVFULEHVWKHG\QDPLFPDUNXSIRUSULFHVHWWLQJ:KHQWKHSULFH
signal Ip
HTXDOV]HURHTXDWLRQEHFRPHV P j MC H t
new
t, ( ) = ( )- - 1 . ith symmetric
HTXLOLEULXPWKHGRPHVWLFDJJUHJDWHSULFHLQGH[LV
P P PH t p H t p H t new
, , ,= + ( ) ( )
( )
1
11
1 1
1 9)
C. Price Level, Terms o Trade, and Real Exchange Rate
he nominal exchange rate Ht is the price of one unit of foreign currency in terms of
domestic currency. Assuming the law of one price holds, P PH t t H t , ,H and P PF t t F t , ,
H . he
terms of trade, StLVGHQHGDVWKHSULFHRIWKHLPSRUWHGJRRGUHODWLYHWRWKHSULFHRIWKH
domestic good S PP
PP
t
F t
H t
t F t
H t
=
,
,
,
,
H ). he real exchDQJHUDWHLVWKHQGHQHGDV H Ht
r t t
t
PP
.
or a small open economy, domestic price changes do not affect the foreign price level.
o without loss of generality, we assume that P PF t t, = , where the foreign price level
is determined by the prices of non-oil goods and oil. ence, it can be expressed as
8 | ADB Economics Working Paper Series No. 299
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P P Pt NO t O t no no = ( ) ( ), ,
J J1
. or simplicity, we normalize PNO t, to one so the foreign non-oil
LQDWLRQSNO t,
LV]HUR7KHWRWDO&3LQDWLRQLVGHQHGDVS t t tP P ( )log 1 and theGRPHVWLFLQDWLRQLVGHQHGDV S H t H t H t P P, , ,log ( )1 .
D. Monetary Policy and Exchange Rate Regimes
ROORZLQJRQDFHOOLGHYLDWLRQVRILQDWLRQRXWSXWDQGQRPLQDOH[FKDQJHUDWH
from their long-run target have feedback effects on short-run movements of the nominal
interest rate target given by
11
1
+( ) =
iP
PYt
t
t
t ty
10)
where it LVWKHLQDWLRQWDUJHWDQG , y and
are weights assigned to the movements
RI&3LQDWLRQRXWSXWDQGQRPLQDOH[FKDQJHUDWHUHVSHFWLYHO\DWKHUWKDQ&3
LQDWLRQHTXDWLRQFRXOGEHPRGLHGWRFRQVLGHUGRPHVWLFLQDWLRQZKHUHLQDWLRQ
could be written as P PH t H t H
, , ( )1
, where HLVWKHZHLJKWRQGRPHVWLFLQDWLRQ7KH
actual short-run interest rate is determined based on the monetary authoritys desire to
smooth changes in the nominal interest rate
1 1 11
1+( ) = +( ) +( )
i i it t tF F
11)
he exogenous stochastic processes for the foreign output, foreign interest rate,
domestic technology, and nominal oil price can be summarized as
Y Yt t tyy exp= ( )1
, 1 1 1+( ) = +( ) ( )i it t tii
exp
, A At t taa= ( )1 exp and
P PO t O t t po
po
,
, exp= ( ) ( )1 , respectively.8
E. Welare
e analyze the impact of various monetary policy regimes based on social welfare loss
function minimized by the central banks. he function is based on the second-order
aylor expansion of the households utility around the steady state as in otemberg and
oodford 1998 and 1999) and oodford 200), and extended to small open economies
by Chung, ung, and ang 200) and ivino 2009). he social welfare loss function is
derived as in alsh 2010) and could be expressed as
^ `E S Of
: 2 2
00
( )flexiblet t t tt
W E y y 12)
8 The rst order conditions, the steady state and market equilibrium, and the log-linearized equations are availablerom the authors upon request.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 9
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where =
( ) ( )
+( )1
2 1 1
1 2U CCp
p p
,
=
( ) ( )
+( )+( )
1 1
1
p p
p, and
flexible
ty is obtained by setting the probability of nonadjustment in price, Mp, close to zero.e set the inverse of elasticity of intertemporal substitution, V, and the elasticity of
substitution between home and foreign produced goods, HTXDOWRIROORZLQJ*DOLDQG
RQDFHOOL7KH\VKRZWKDWXVLQJWKLVVSHFLFDWLRQWRJHWKHUZLWKWKHDVVXPSWLRQV
of purchasing power parity and uncovered interest parity, the combined effects of
PDUNHWSRZHUDQGWHUPVRIWUDGHGLVWRUWLRQVFRXOGEHRIIVHWVRWKDWXQGHUH[LEOHSULFH
HTXLOLEULXPGRPHVWLFLQDWLRQWDUJHWLQJLVWKHRSWLPDOPRQHWDU\SROLF\(TXDWLRQ
measures welfare loss as a second order approximation to the utility loss of the domestic
consumer resulting from deviations from optimal monetary policy. ollowing ucas 198),
DOWHUQDWLYHPRQHWDU\SROLFLHVDUHVSHFLHGLQWKHFRQWH[WRIDVLPSOH'6*(PRGHODQG
the welfare losses are compared to draw policy implications.
F. Model Parameterization
he model is solved numerically and parameterized following Monacelli 2004).9 he
marginal disutility of work effort M is set to . As common in the Calvo 198) pricing
models, the probability of price nonadjustment, I, is set at 0.5. he steady-state
markup, --HTXDOVWR7KHODERUVKDUHRIRXWSXWHTXDOV7KHHODVWLFLW\RI
investment rate to the price of capital KHTXDOV
he monetary policy regime parameters are set as follows he interest rate smoothing
parameter, F, is 0.5. ZHIRU[HGRUSHJJHGH[FKDQJHUDWHZKLOHZH = 0.1 for
H[LEOHH[FKDQJHUDWHQGHUWKHH[LEOHH[FKDQJHUDWHUHJLPHWKHFHQWUDOEDQNFRXOGFKRRVHWRWDUJHWRQO\&3LQDWLRQVRZS= 1.5 and ZyRURQO\GRPHVWLFLQDWLRQVXFK
that ZS+ = 1.5 and ZyRUFKRRVHWRIROORZWKH7D\ORUUXOHVRZS = 1.5 and Zy
or target nominal output and set ZS = 1.5 and Zy = 1.5 or real output and set ZS = 0 and
Zy7KHFHQWUDOEDQNFRXOGDOVRWDUJHW&3LQDWLRQDQGH[FKDQJHUDWHDQGVHW
ZS= 1.5, Zy = 0 and ZH = 0.8.
As in Alba, u, and Chia 2011), the parameters of the serial correlation of the oil price
shocks Uy), foreign interest rate Ui), foreign output Uy), and technology Ua ) are set
to 0.90. he degrees of the impact of oil price on the foreign price level JNOHTXDOV
IRUDSRVLWLYHRLOSULFHVKRFNDQGIRUDQHJDWLYHRLOSULFHVKRFN7KHVHUHHFW
the asymmetric effect of oil price shocks.10 hese asymmetric effects also imply thatDSRVLWLYHRLOSULFHVKRFNKDVVLJQLFDQWHIIHFWRQPDUJLQDOFRVWZKLOHDQHJDWLYHRLO
price shock has negligible effect on marginal cost. he share of capital relative to oil in
production L) is 0.90. he standard deviations from the steady state of oil price
Po
) of
9 The numerical solution o the model is described in Uhlig (1997).10 For example, Chen, Finney, and Lai (2005) nd empirical evidence that gasoline prices in the US respond quickly to
a crude oil price increase but not to a decrease.
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foreign nominal interest rate i
) and of technology a) are set at 1. he standard
GHYLDWLRQRIIRUHLJQRXWSXWIURPWKHVWHDG\VWDWHLVVHWWRRYHURQHSHULRG
he inverse of the elasticity of substitution between oil and capital, X, is calculated
from the expression of the steady state of the oil to capital ratio as a function of
the parameters X,G,E, and L.11:HIROORZLPDQGRXQJDQLLQVHWWLQJWKH
depreciation rate, GHTXDOVWRDQGWKHGLVFRXQWUDWHEHTXDOVWR7KH
share of oil relative to capital stock, 1L), is 0.10. iven these parameter values, X is
FDOFXODWHGEDVHGRQDYHUDJHHQHUJ\WRFDSLWDOUDWLRRIIRUQGRQHVLDIRUWKH
3KLOLSSLQHVIRUDOD\VLDIRU7KDLODQGIRUWKHHSXEOLFRIRUHD
IRU6LQJDSRUHIRU+RQJRQJ&KLQDIRU7DLSHL&KLQDDQGIRUWKHQLWHG
tates ), which is our benchmark country. hese values are used to calculate X of 9.
IRUQGRQHVLDIRUWKH3KLOLSSLQHVIRUDOD\VLDIRU7KDLODQGIRUWKHHSXEOLF
RIRUHDIRU6LQJDSRUHIRU+RQJRQJ&KLQDIRU7DLSHL&KLQDDQG
for the .127KHHVWLPDWHVIRUWKH6DUHFRPSDUDEOHWRLPDQGRXQJDQLVVHWWLQJ
ofXHTXDOVWRDQGDQHODVWLFLW\RIVXEVWLWXWLRQRIIRUWKH6$VDSUR[\IRUWKH
SDUDPHWHURQWKHSURSRUWLRQRIIRUHLJQJRRGVLQWRWDOFRQVXPSWLRQ J), we use imports
over of ast Asian countries as shown in able 1.
IV. Simulation Results and Welare
n this section, we report and discuss our simulation results, including estimates ofwelfare losses under alternative monetary policy regimes.
A. Impulse Responses under Various Monetary Policy Regimes
7KHVLPXODWHGLPSXOVHUHVSRQVHVLQLJXUHVUHSUHVHQWWKHG\QDPLFUHVSRQVHVRI
UHDORXWSXWLQDWLRQWHUPVRIWUDGHQRPLQDOUDWHVDQGUHDOH[FKDQJHUDWHVXQGHUVHYHQ
PRQHWDU\SROLF\UHJLPHV[HGRUSHJJHGH[FKDQJHUDWHUHJLPHVWULFW&3LQDWLRQ
WDUJHWLQJH[FKDQJHUDWHDQG&3LQDWLRQWDUJHWLQJWKH7D\ORUUXOHVWULFWGRPHVWLF
LQDWLRQWDUJHWLQJQRPLQDO*'3WDUJHWLQJDQGUHDO*'3WDUJHWLQJ
11 The steady-state capitaloil ratio is given by
K
O
Z
( )
=
1, where
Z= +
11
, which is the steady-
state rental cost o capital. The details o the derivation are available rom the authors upon request.12 Data on energy use in kiloton o oil equivalent (KOE) and gross capital ormation are rom the World Economic
Indicators or Hong Kong, China; Indonesia; the Republic o Korea; Malaysia; Philippines; Singapore; and the US.Data or Taipei,China are rom the CEIC Database. We calculate energy use by multiplying energy use in KOE by theaverage price o a kiloton o crude oil in 2000 US dollars. We use the CPI to convert energy use in 2000 US dollarsto 1985 international dollars in relation to the US. Data on CPI and the price o crude oil are rom the InternationalFinancial Statistics online.
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Figure 1: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under Fixed/Pegged Exchange Rate
33
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
Source: Authors' estimates.
Figure 2: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under CPI Infation Targeting
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.
Source: Authors' estimates.
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Figure 3: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under Exchange Rate and CPI Infation Targeting
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.Source: Authors' estimates.
Figure 4: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under Taylor Rule
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
0.4
0.5
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.Source: Authors' estimates.
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Figure 5: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: with Domestic Infation Targeting
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.Source: Authors' estimates.
Figure 6: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: with Nominal GDP Targeting
0.4
0.2
0
0.2
0.4
0.6
0.8
1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
CPI = consumer price index, GDP = gross domestic product.Source: Authors' estimates.
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Figure 7: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: with Real GDP Targeting
0.2
0
0.2
0.4
0.6
0.8
1
1.2
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms o trade Domestic ination
CPI ination Nominal exchange rate
Real exchange rate Output
CPI = consumer price index, GDP = gross domestic product.Source: Authors' estimates.
$QHJDWLYHIRUHLJQRXWSXWVKRFNKDVWKHELJJHVWLPSDFWRQGRPHVWLFRXWSXWXQGHU[HGRU
SHJJHGH[FKDQJHUDWHUHJLPHIROORZHGE\&3LQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJ&3
LQDWLRQWDUJHWLQJGRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDO*'3WDUJHWLQJ
and the least under real targeting. or a 1 decline in foreign output, real output
GHFOLQHVIURPLWVVWHDG\VWDWHE\XQGHU[HGH[FKDQJHUDWHUHJLPHXQGHU
&3LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJXQGHU&3LQDWLRQWDUJHWLQJ
XQGHUGRPHVWLFLQDWLRQWDUJHWLQJXQGHU7D\ORUUXOHDQGXQGHUQRPLQDO
RXWSXWQGHUUHDORXWSXWWDUJHWLQJLWULVHVE\LQWKHUVWSHULRGEHIRUHGHFOLQLQJE\
0.08.
he mitigated effect on real output under real and nominal output targeting and to a
lesser extent, aylor-type rule, could be explained by the large and sharp depreciation
in the nominal exchange rate following a negative foreign output shock. n the period
following the 1 negative foreign output shock, nominal exchange rate depreciates
from the steady state value by 0.4 for real output targeting, 0.5 for nominal output
targeting, and 0.24 for aylor-type rule. n turn, the large exchange rate depreciation
LQFUHDVHVWKHSULFHVRIRLODQGRWKHULPSRUWVFDXVLQJKLJKHUWRWDO&3LQDWLRQLNHZLVH
H[SHFWDWLRQVRIKLJKHULQDWLRQDQGIXUWKHUGHSUHFLDWLRQUDLVHWKHQRPLQDOLQWHUHVWUDWH
he impact on the nominal interest rate is shown in igure 8 where a 1 negative
foreign output shock increases nominal interest rate by 0.41, 0.11, and 0.08 from
the steady state for nominal output targeting, real output targeting, and aylor-type rule,
respectively. n contrast, nominal exchange rate depreciates only by 0.08, 0.02,
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DQGIRU&3LQDWLRQGRPHVWLFLQDWLRQDQG&3LQDWLRQFXPH[FKDQJHUDWH
WDUJHWLQJUHVSHFWLYHO\7KLVOHDGVWRDUHGXFWLRQRI&3LQDWLRQIURPLWVVWHDG\VWDWH
E\IRU&3LQDWLRQWDUJHWLQJIRUSHJJHGH[FKDQJHUDWHUHJLPHDQG&3
LQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJDQGIRUGRPHVWLFLQDWLRQWDUJHWLQJWZR
periods after the shock. ence, nominal interest rate in igure 8 shows a decline fromVWHDG\VWDWHYDOXHVRIDQGIRU&3LQDWLRQGRPHVWLFLQDWLRQ
DQG&3LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJUHVSHFWLYHO\7KHQRPLQDOLQWHUHVWUDWH
hardly changes under pegged exchange rate regime. he impulse responses clearly show
DWUDGHRIIEHWZHHQORZHURXWSXWYRODWLOLW\DQGKLJKHULQDWLRQDQGQRPLQDOLQWHUHVWUDWH
volatility.
Figure 8: Impulse Responses o Interest Rate to a Negative Foreign
Figure 5: Output Shock Under Various Monetary Policies
0.1
0.08
0.06
0.04
0.02
0
0.02
0.04
0.06
0.08
0.1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Pegged exchange rate Taylor-type rule
CPI ination targeting Domestic ination targeting
CPI inationexchange rate targeting Nominal output targeting
CPI = consumer price index.Source: Authors' estimates.
B. Welare Losses under Various Monetary Policies
e examine the impact of various monetary policies after a negative foreign output
shock using a welfare loss function described in ection , and shown in able 2
with the model parameters of oil-to-capital ratio of 0.25 and import-to- ratio of 0.5
taken as average values for ast Asian countries. he results show from least to most
ZHOIDUHORVVHVDVFRPSDUHGZLWKWKHRSWLPDOPRQHWDU\SROLF\DUHDVIROORZV&3LQDWLRQ
WDUJHWLQJ&3LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJSHJJHGH[FKDQJHUDWHUHJLPH
GRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDORXWSXWWDUJHWLQJDQGUHDORXWSXW
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WDUJHWLQJ:LWKFRPSOHWHSDVVWKURXJK&3LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUH
loss under negative foreign output shock.
Table 2: Welare Loss ater a Negative Foreign Output Shock
Table 2: under Dierent Monetary Policies
Monetary Policy
Weights in the Interest Rate Rule Welare
Loss H y
Fixed /pegged exchange rate regime 0 0 0 0.99 2.35
CPI ination targeting 1.5 0 0 0.1 0.71
Exchange rate and ination targeting 1.5 0 0 0.8 1.91
Taylor-type rule 1.5 0 0.5 0.1 10.13
Domestic ination targeting 0 1.5 0 0.1 3.69
Nominal output targeting 1.5 0 1.5 0.1 49.25
Real output targeting 0 0 1.5 0.1 122.14
CPI = consumer price index, GDP = gross domestic product.Note: Welare loss is calculated based on the average percentage o imports over real GDP o 50% or the six East Asian countries
excluding Hong Kong, China and Singapore, which have percentage imports over GDP o 172% and 191%, respectively. Theaverage oil-to-capital ratio is 0.25 and the average elasticity o substitution o oil-to-capital is 3.14, excluding the Philippinesand Indonesia, which have an average oil-to-capital (elasticity o substitution o oil or capital) o 0.58 (7.8) and 0.90 (9.3),respectively. In the model, the import to GDP is (1) equals 0.5 while the elasticity o substitution o oil and capital is . ,H, y, and are the weights on overall ination, domestic ination, output gap, and exchange rate in the interest rate
rule equation. 1 in which optimal monetary policy under exible price equilibrium is domestic ination targetingas in Gali and Monacelli (2005).
Source: Authors' estimates.
ince there are large variations in import-to- ratio among ast Asian countries, we
FRQGXFWVHQVLWLYLW\DQDO\VLVEDVHGRQWKLVUDWLRUHSUHVHQWHGE\WKHSDUDPHWHU
his is the proportion of import in household consumption in the model. able shows
the estimates of welfare losses due to a 1 negative output shock for various ratiosof import-to- given an oil-to-capital ratio of 0.25 under different monetary policy
UHJLPHV7KHUHVXOWVVKRZWKDWIRUDQHFRQRP\ZLWKLPSRUWWR*'3UDWLRRI&3LQDWLRQ
WDUJHWLQJSHJJHGH[FKDQJHUDWHUHJLPHDQGDFRPELQDWLRQRI&3LQDWLRQDQGH[FKDQJH
rate targeting minimize the welfare losses.
RUDQHFRQRP\ZLWKLPSRUWWR*'3UDWLRRIGRPHVWLFLQDWLRQWDUJHWLQJGHOLYHUV
WKHOHDVWZHOIDUHORVVIROORZHGE\&3LQDWLRQWDUJHWLQJDQGWKHQ7D\ORUW\SHUXOHRU
FRXQWULHVZLWKLPSRUWWR*'3UDWLRVRI&3LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVW
ZHOIDUHORVVRULPSRUWWR*'3RI&3LQDWLRQWDUJHWLQJH[FKDQJHUDWHSHJDQG
&3LQDWLRQFXPH[FKDQJHUDWHSHJKDYHHTXLYDOHQWZHOIDUHORVVHV+HQFHFRXQWULHV
ZLWKDODUJHLPSRUWFRPSRQHQWFRXOGFRQWUROLQDWLRQXVWDVZHOOE\WDUJHWLQJH[FKDQJHUDWHVVLQFHLPSRUWHGLQDWLRQPDNHVXSDODUJHSURSRUWLRQRIRYHUDOORU&3LQDWLRQ
hese results are consistent with the literature under complete exchange rate pass
WKURXJKQDUHODWLYHO\FORVHGHFRQRP\GRPHVWLFLQDWLRQWDUJHWLQJVWDELOL]HVGRPHVWLF
prices and output. As the level of opennessproxied by the import-to- ratiorises,
increasing the ratio of foreign goods in the consumption basket so that C targeting
stabilizes overall prices and output.1
13 Chung, Jung, and Yang (2007) note that the lower levels o openness could be less relevant with incompleteexchange rate pass through.
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Table 3: Welare Loss ater a Negative Foreign Output Shock Under Dierent Monetary
Table 3: Policies and Various Values o Import over GDP
Imports
over GDP
Monetary Policy
Fixed/
PeggedExchange
Rate Regime
CPIInfation
Targeting
Exchange
Rate andInfation
Targeting
Taylor-type
Rule
DomesticInfation
Targeting
NominalIncome
Targeting
RealIncome
Targeting
1.0 0.44 0.44 0.44 55.65 10.04 246.11 693.19
0.9 0.57 0.37 0.51 42.18 8.56 187.02 515.26
0.7 1.53 0.51 1.22 22.37 5.91 101.58 265.77
0.5 2.35 0.71 1.91 10.13 3.69 49.25 122.14
0.3 2.33 0.78 1.97 3.47 1.06 19.92 47.48
0.1 1.42 0.61 1.28 0.64 0.53 5.60 13.56
CPI = consumer price index, GDP = gross domestic product.Note: We use import over GDP as a proxy or (1) in the model. The elasticity o oil-to-capital is set at 3.14 as in Table 2.
1 in which optimal monetary policy under exible price equilibrium is domestic ination targeting as in Gali andMonacelli (2005).
Source: Authors' estimates.
e also calibrate the model for a pair of economies based on their ratios of oil to capital
and of import to and calculate the welfare losses under various monetary policy
UHJLPHV7KHSDLUVRIHFRQRPLHVDUH+RQJRQJ&KLQDDQG6LQJDSRUHWKHHSXEOLFRI
RUHDDQG7DLSHL&KLQDDOD\VLDDQG7KDLODQGDQGQGRQHVLDDQGWKH3KLOLSSLQHV7KH
estimates of welfare losses under various monetary policy regimes are shown in able 4.
7KH\VKRZWKDWHLWKHU[HGSHJJHGH[FKDQJHUDWHUHJLPHVRU&3LQDWLRQWDUJHWLQJ
GHOLYHUWKHOHDVWZHOIDUHORVVIRU+RQJRQJ&KLQDDQG6LQJDSRUHQWKHRWKHUKDQG
&3LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUHORVVIRUQGRQHVLDWKHHSXEOLFRIRUHD
DOD\VLDWKH3KLOLSSLQHV7DLSHL&KLQDDQG7KDLODQG
Table 4: Welare Loss ater a Negative Foreign Output Shock under Dierent Monetary
Table 3: Policies Calibrated or Various East Asian Countries
Country
Monetary Policy
Fixed/
Peg
Exchange
Rate Regime
CPI
Infation
Targeting
Exchange
Rate and
Infation
Targeting
Taylor-
type
Rule
Domestic
Infation
Targeting
Nominal
Income
Targeting
Real
Income
Targeting
Hong Kong, China and Singapore 0.47 0.47 0.47 56.90 10.97 258.76 720.08
Korea, Rep. o and Taipei,China 2.44 0.77 2.02 5.98 1.87 29.93 79.34
Malaysia and Thailand 0.93 0.39 0.77 31.01 17.66 134.55 357.72
Indonesia and the Philippines 2.27 0.73 1.87 6.47 1.87 31.53 70.50
CPI = consumer price index, GDP = gross domestic product.Note: Hong Kong, China and Singapore have an average import over GDP o 1, and elasticity o substitution o 2.1. The Republic
o Korea and Taipei,China have an average import over GDP o 0.4 and an elasticity o substitution o oil and capital o 2.3.Malaysia and Thailand have an average import over GDP o 0.8 and an elasticity o substitution o oil and capital o 5.1.Indonesia and the Philippines have an average import over GDP o 0.4 and an elasticity o substitution o oil and capital o
8.5. 1 in which optimal monetary policy under exible price equilibrium is domestic ination targeting as in Galiand Monacelli (2005).
Source: Authors' estimates.
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C. Summary o Simulation Results and Welare
Consistent with the empirical evidence documented by offman 200), the comparison
EHWZHHQUHVSRQVHVRIDOWHUQDWLYHPRQHWDU\SROLF\UHJLPHVVXJJHVWVWKDWLERWK[HG
H[FKDQJHUDWHUHJLPHDQGLQDWLRQWDUJHWLQJWHQGWRVWDELOL]HUHDOH[FKDQJHUDWHDQGLQDWLRQDWWKHH[SHQVHRIVXEVWDQWLDOLQVWDELOLW\LQWKHUHDOHFRQRP\LLWKHPLWLJDWHG
decline in real output under the aylor-type rule is explained by the large depreciation
RIQRPLQDODQGUHDOH[FKDQJHUDWHVDQGLLLLQDWLRQUDWHLVORZHVWXQGHU&3LQDWLRQ
targeting. n addition, the decline in output is smallest under nominal and real
targeting due to the higher rate of nominal and real exchange rate depreciation. owever,
ERWKRXWSXWWDUJHWLQJDOVROHGWRWKHZRUVWLQDWLRQRXWFRPH&RQVLVWHQWZLWKULHGPDQV
SUHGLFWLRQVORQJUXQGLIIHUHQFHVDFURVVUHJLPHVDUHQRWVLJQLFDQW
e also compare the welfare effects of the various monetary policy regimes as compared
ZLWKWKHRSWLPDOPRQHWDU\SROLF\XQGHUH[LEOHSULFHVXVLQJDTXDGUDWLFVRFLDOZHOIDUH
loss function. e show that with an average oil-to-capital ratio of 0.2 and import-to-UDWLRRI&3LQDWLRQWDUJHWLQJOHDGVWRWKHOHDVWZHOIDUHORVVIROORZHGE\LQDWLRQ
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targeting, aylor-type rule, and nominal and real output targeting. he simulation results
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aylor-type rule or nominal and real output targeting due to the large depreciation in the
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2010).
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exchange rate targeting is comparable to countries with either pegged exchange rate or&3LQDWLRQWDUJHWLQJ+RZHYHULIWKHUDWLRLVEHWZHHQDQG&3LQDWLRQFXP
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targeting.
ince ast Asian economies vary a lot with respect to the ratio of import-to-, ranging
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calculate the welfare loss of various monetary policy regimes for ratios between 10
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loss as it also stabilizes output. hen import-to- ratio is between 0. and 0.9, C
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V. Conclusions
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were severely affected by the deep recession of the advanced economies. his reignites
the debate about the appropriate monetary policy regime for a small open economy
subject to external shocks. he primary objective of our paper is to evaluate and compare
the welfare impact of external output shocks acting through the trade channel in eight
ast Asian countries with different monetary policy regimes. o do so, we use a simple
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LQWKHJRRGVPDUNHW7KHDOWHUQDWLYHPRQHWDU\SROLF\UHJLPHVFRQVLGHUHGDUH[HGRU
SHJJHGH[FKDQJHUDWHUHJLPH&3DQGGRPHVWLFLQDWLRQWDUJHWLQJ&3LQDWLRQFXP
exchange rate targeting, the aylor-type rule, and nominal and real output targeting.
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to foreign output shocks across monetary policy regimes. Compared to a aylor-type
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prevents the real exchange rate from depreciating. he negative impact of a fall in foreign
output is thus largely passed to the domestic economy. he mitigated decline in real
output under a aylor-type rule and nominal and real targeting is explained by a larger
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ORZHVWXQGHU&3LQDWLRQWDUJHWLQJDQGQRPLQDOH[FKDQJHUDWHLVVWDEOHXQGHUSHJVXU
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ur simulation results are also broadly consistent with the stylized facts of the ast
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smallest volatility in exchange rate but suffered the largest cumulative reduction in real
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targeting, experienced larger currency depreciation but suffered a smaller cumulative
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rate regimes give the least welfare losses in light of their high ratios of imports to .
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hilippines, and hailand since it offers the least welfare loss. his is consistent with the
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At a broader level, our analysis can provide some guidance about monetary policy
regimes for small open economies. or such economies, which depend heavily onexports and trade for growth, the capacity of monetary policy to cushion the impact of
adverse external output shocks is one of the most important criteria for the appropriate
policy regime. he pronounced impact of the recession in the advanced economies on
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XUKLJKO\VLPSOLHG'6*(PRGHOVLPXODWLRQUHVXOWVVXJJHVWWKDW&3LQDWLRQWDUJHWLQJ
delivers the least welfare loss for most ast Asian small open economies except for those
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&3LQDWLRQWDUJHWLQJIRUVPDOORSHQHFRQRPLHVPD\EHWKDWLWSURWHFWVWKHPEHWWHUIURP
external output shocks.
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A Welare Evaluation o East Asian Monetary Policy Regimes under Foreign Output Shock
Joseph D. Alba, Wai-Mun Chia, and Donghyun Park assess the welare impact o external shocksunder diferent monetary policy regimes in East and Southeast Asia. To do so, they numericallysolve and calculate the welare loss unction o a dynamic stochastic general equilibrium (DSGE)model with complete exchange rate pass through. Their DSGE model simulation results suggestthat consumer price index ination targeting delivers the least welare losses or most small open
economies in East and Southeast Asia.
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