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This paper builds a DSGE model for a small open economy (SOE) in which the central bank systematically intervenes both the domestic currency bond and the FX markets using two policy rules: a Taylor-type rule and a second rule in which the operational target is the rate of nominal currency depreciation. For this, the instruments used by the central bank (bonds and international reserves) must be included in the model, as well as the institutional arrangements that determine the total amount of resources the central bank can use. The 'corner' regimes in which only one of the policy rules is used are particular cases of the model. The model is calibrated and implemented in Dynare for 1) simple policy rules, 2) optimal simple policy rules, and 3) optimal policy under commitment. Numerical losses are obtained for ad-hoc loss functions for different sets of central bank preferences (styles). The results show that the losses are systematically lower when both policy rules are used simultaneously, and much lower for the usual preferences (in which only inflation and/or output stabilization matter). It is shown that this result is basically due to the central bank's enhanced ability, when it uses the two policy rules, to influence capital flows through the effects of its actions on the endogenous risk premium in the (risk-adjusted) interest parity equation.

This paper builds a DSGE model for a SOE in which the central bank systematically intervenes both the domestic currency bond and the FX markets using two policy rules: a Taylor-type rule and a second rule in which the operational target is the rate of nominal currency depreciation. For this, the instruments used by the central bank (bonds and international reserves) must be included in the model, as well as the institutional arrangements that determine the total amount of resources the central bank can use. The 'corner' regimes in which only one of the policy rules is used are particular cases of the model. The model is calibrated and implemented in Dynare for 1) simple policy rules, 2) optimal simple policy rules, and 3) optimal policy under commitment. Numerical losses are obtained for ad-hoc loss functions for different sets of central bank preferences (styles). The results show that the losses are systematically lower when both policy rules are used simultaneously, and much lower for the usual preferences (in which only inflation and/or output stabilization matter). It is shown that this result is basically due to the central bank's enhanced ability, when it uses the two policy rules, to influence capital flows through the effects of its actions on the endogenous risk premium in the (risk-adjusted) interest parity equation.

This thesis consists of an introductory chapter and three essays, all of which aim to study the functioning of a small open economy. The thesis starts with an investigation of export and import price determination and moves to a small open economy DSGE model framework in order to study the role of financial factors in economic fluctuations. In all three essays, theoretical small open economy models are used for quantitative analysis of the small open economy of Finland. The first essay develops a model for aggregate trade price inflation that takes into account two price setting conventions: local currency pricing (LCP) and producer currency pricing (PCP). In our empirical work, we confront our model with Finnish data and estimate the relative shares of LCP and PCP firms in the economy. In the estimation period 1980 1998, the share of local currency pricing was 40 percent in the export sector and 60 percent in the import sector, implying a limited pass-through from exchange rate to destination-country prices in both sectors. The second essay builds a small open economy DSGE model with the BGG financial accelerator and financial market shocks. In our empirical work covering the period 1995 2008, we provide evidence of an operative financial accelerator in Finland. The financial accelerator acts as an amplifying mechanism for many disturbances hitting the Finnish economy. Our main result is that financial market disturbances have contributed significantly to Finnish cyclical fluctuations between 1995 and 2008. Even allowing for several shocks stemming from both domestic sources and the international economy, domestic financial market shocks emerge as key drivers of recent business cycle fluctuations in Finland. The third essay studies the boom-bust period in Finland in the late 1980s and early 1990s, focusing on the role of financial factors and investment behaviour. We construct a small open economy DSGE model with the BGG financial accelerator and an unconventional shock structure that captures the key events of the episode. In this model framework, we study the role of financial market deregulation in the boom, the negative impact of the collapse of Soviet-Finnish trade in 1991, and the effect of the collapse of the fixed exchange rate regime in 1992. We argue that the financial accelerator mechanism is a key amplifying mechanism that helps the model to match, in particular, the large and persistent swings of investment first above and later below its trend. This essay demonstrates that the shocks Finland encountered combined with financial frictions are able to produce a boom and a severe depression, matching key salient features of the actual boom-bust cycle experienced in Finland in the late 1980s and early 1990s. Väitöskirja koostuu johdannosta ja kolmesta tutkimusluvusta, joiden tutkimuskohteena on pienen avoimen talouden toiminta. Väitöskirjassa tutkitaan ensin vienti- ja tuontihintojen määräytymistä, minkä jälkeen tarkastellaan rahoitustekijöiden merkitystä reaalitalouden vaihteluissa. Kaikissa kolmessa tutkimusluvussa teoreettisia pientä avotaloutta kuvaavia malleja käytetään Suomen talouskehityksen kvantitatiiviseen analyysiin. Ensimmäisessä tutkimusluvussa kehitetään kansainvälisesti kaupattavien hyödykkeiden inflaatiokehitystä kuvaava malli, jossa ulkomaankaupan hinnat voivat olla jäykkiä joko ostajan valuutassa (hinnoittelu paikallisen valuutan määräisenä) tai myyjän valuutassa (hinnoittelu tuottajan valuutan määräisenä). Empiirisessä työssä estimoidaan Suomen tilastotietoja käyttäen ostajan ja myyjän valuutassa hinnoittelevien yritysten suhteellinen osuus taloudessa. Estimointiajanjaksona 1980 1998 ostajan valuutassa hinnoittelevien yritysten estimoitu osuus oli 40 % vientisektorilla ja 60 % tuontisektorilla. Näin ollen valuuttakurssin läpimeno kohdemaan tuontihintoihin oli estimointiajanjaksolla epätäydellinen sekä vienti- että tuontisektorilla. Toisessa tutkimusluvussa rakennetaan pienen avotalouden makromalli, jossa rahoitusmarkkinoiden toiminta vaikuttaa reaalitalouteen erityisesti investointien kautta. Ajanjaksoa 1995-2008 koskevien tulosten mukaan Suomen taloudessa toimii ns. rahoitusakseleraattori, jonka takia investointeja varten tarvittavan ulkoisen rahoituksen hinta riippuu lainanottajien taseiden vahvuudesta. Rahoitusakseleraattori voimistaa monien Suomen talouteen kohdistuvien sokkien vaikutuksia. Lisäksi tutkimuksessa osoitetaan, että yllättävät muutokset lainanottajien rahoituskustannuksissa (ns. rahoitusmarkkinasokit) selittävät suuren osan investointien ja sitä kautta kokonaistuotannon suhdannevaihteluista Suomessa vuosina 1995-2008. Kolmannessa tutkimusluvussa tutkitaan Suomen talouden ylikuumenemista 1980-luvun lopulla sekä 1990-luvun alun lamaa keskittymällä erityisesti rahoitustekijöiden ja investointien merkitykseen. Työssä rakennetaan pienen avotalouden makromalli, jossa on rahoitusakseleraattori sekä sokkirakenne, joka formalisoi aikakauden keskeiset tapahtumat. Tässä mallikehikossa arvioidaan rahoitusmarkkinoiden vapauttamisen merkitystä 1980-luvun talouden ylikuumenemisessa, vuoden 1991 Suomen Neuvostoliiton-kaupan romahduksen epäsuotuisia vaikutuksia sekä vuoden 1992 kiinteästä valuuttakurssijärjestelmästä luopumisen vaikutuksia. Keskeinen tutkimustulos on, että rahoitusakseleraattorilla on tärkeä sokkien seurauksia voimistava vaikutus, mikä auttaa mallia toistamaan erityisesti investointien suuret ja pitkäaikaiset vaihtelut trendinsä ylä- ja alapuolelle. Tässä tutkimusluvussa osoitetaan, että Suomeen kohdistuneet sokit yhdistettynä rahoitustekijöihin pystyvät aikaansaamaan talouden ylikuumenemisen ja syvän laman ja toistamaan Suomen 1980-luvun lopun ja 1990-luvun alun toteutuneen talouskehityksen keskeiset piirteet.

In this paper we present an analysis of the impact of the great recession of the years 2008 and 2009 on the Austrian economy. For this purpose, we utilize the new estimated DSGE model of the OeNB for the Austrian economy within the Euro area. This model is a small open-economy version of Smets & Wouters (2003), where the domestic economy is linked to a highly stylized representation of the rest of the Euro area via trade and financial flows. The model identifies foreign demand and confidence shocks as the main transmission channels. Moreover the risk premium shock contributed significantly to the downturn of the Austrian economy. In contrast price shocks (price markup and raw material shocks) were supportive throughout the crisis. The strong resilience of the Austrian labour market during the crisis and the subsequent upswing is reected in a series of negative technology shocks.

This paper simulates the impact of a short-term shock originating from the global financial system on small open economies in the Association of Southeast Asian Nations (ASEAN). The simulation uses empirically estimated general equilibrium models for Indonesia, Malaysia, the Philippines, and Thailand. The study finds that the impact of a pure international financial shock on aggregate domestic price inflation and on output gap for each of the four ASEAN countries tends to be relatively small but long-lasting, placing challenges in the medium- to long-term management of economic volatility.

This paper uses the EAGLE, a multi-country dynamic general equilibrium model, to illustrate dynamic adjustments in a small open economy undergoing real convergence. We consider the effects of productivity catch-up and misperceptions about future productivity developments. Our results indicate that even if real convergence takes the form of a gradual process, the dynamic responses of key macrovariables can be far from smooth. We also find that overly optimistic expectations about productivity shifts can generate sizable boom-bust cycles and so be relevant in accounting for cyclical deviations from a sustainable real convergence path. Our comparisons across alternative monetary regimes reveal that a flexible exchange rate helps to smooth real convergence processes and misperceptions associated with tradable sector productivity, while the opposite usually holds true for scenarios based on nontradable sector developments.

The curse of dimensionality, a problem associated with analyzing the interaction of a relatively large number of endogenous macroeconomic variables, is a prevailing issue in the open economy macro literature. The most common practise to mitigate this problem is to apply the so-called Small Open Economy Framework (SOEF). In this paper, we aim to review under which conditions the SOEF is a justifiable approximation and how severe the consequences of violation of key conditions might be. Thereby, we use a multicountry general equilibrium model as a laboratory. First, we derive the conditions that ensure the existence of the equilibrium and study the properties of the equilibrium using large N asymptotics. Second, we show that the SOEF is a valid approximation only for economies (i) that have a diversified foreign trade structure and if (ii) there is no globally dominant economy in the system. Third, we illustrate that macroeconomic interdependence is primarily related to the degree of trade diversification, and not to the extent of trade openness. Furthermore, we provide some evidence on the pattern of global macroeconomic interdependence by calculating probability impulse response functions in our calibrated multicountry model using data for 153 economies.

Rational expectations model for simulation (REMS) is a state-of-the-art DynamicStochastic General Equilibrium model (DSGE model) of the kind used in many pol-icy institutions throughout the world. It shares a number of common features withstandard models along this line of research, but also displays a number of specificfeatures that makes it appealing for fiscal policy simulations. Indeed, among otherparticular features REMS encompasses: (i) a wider coverage of fiscal variables thanin standard DSGE models, and (ii) a labour market specified along the lines of the“search”framework.WhileIthinkthatthemodelis,ingeneral,arelevantcontributionto the literature, in my discussion I will hinge upon some weaknesses and problemswith the modelling approach and the interpretation of the results that can be identified.For the sake of brevity I will focus on just a few points, grouped in two blocks. First, Iwill comment on non-standard features of REMS, as any critique to features standardin the relevant literature will make no justice to this particular model. Second, I willdiscuss some additional issues.

This paper studies the transmission of shocks and the trade-offs between stabilizing CPI inflation and alternative measures of the output gap in Ramses, the Riksbank's empirical dynamic stochastic general equilibrium (DSGE) model of a small open economy. The main results are, first, that the transmission of shocks depends substantially on the conduct of monetary policy, and second, that the trade-off between stabilizing CPI inflation and the output gap strongly depends on which concept of potential output in the output gap between output and potential output is used in the loss function. If potential output is defined as a smooth trend this trade-off is much more pronounced compared to the case when potential output is defined as the output level that would prevail if prices and wages were flexible.

We study the transmission of monetary shocks and monetary policy with a behavioral model, corrected for potential misspecification using the DSGE-VAR framework elaborated by DelNegro and Schorfheide (2004). In particular, we investigate if the central bank should react to movements in the nominal exchange rate. We contribute to the empirical literature as we use Swiss data, which is very rarely used in that context.

Which are the main frictions and driving forces of business cycle dynamics in a small open economy? To answer this question we extend what is becoming the standard new Keynesian model in three dimensions. First, we incorporate frictions in the financing of the capital stock. Second, we model employment frictions in the labor market using a search and matching framework, allowing for endogenous job separations. Third, we extend the model into a small open economy setting. We estimate the model using Bayesian techniques on Swedish data. Our main results are: i) A financial shock to entrepreneurial wealth is pivotal for explaining business cycle fluctuations accounting for substantial amounts of the variance in investment and GDP. ii) The marginal efficiency of investment shock has very limited importance when we match financial market data. iii) Our model does not need any high frequency wage markup shocks to match the data. Furthermore, the labor supply shock is unimportant in explaining GDP. iv) The data indicates that there are costs of hiring, but no costs of vacancy postings per se.

The carbon emissions abatement, undertaken by some countries, may induce other countries to increase their own emissions. This effect, known as "carbon leakage", may be due to rather different mechanisms. The simplest case is when outside countries do not change their environmental policies and world prices are fixed. Unilateral policies may then induce a substitution of domestic production, generating emissions, with imports.This paper analyses the carbon leakage generated under the "small open economy" assumption, illustrating some findings through a numerical, dynamic, general equilibrium model of the Italian economy. The analysis highlights two main points. First, in a general equilibrium setting, the carbon leakage depends on both the substitution and income effects. Income effects, in turn, crucially depend on how carbon tax revenues are recycled, or pollution rights rents are assigned. Different recycling schemes have rather different impacts on the national income and on the trade-induced leakage. Second, carbon leakage may be significantly affected by the degree of capital mobility in international markets, because capital services enter the balance of trade. Capital outflows amount to exports of capital services, possibly financing the import of carbon-intensive goods. This result suggests that, in a world of increasingly integrated financial markets, unilateral environmental policies are becoming less effective, because of the existence of policy spill-overs.

This paper presents the model used for simulation purposes within the Spanish Ministry of Economic Affairs and Finance. REMS (a Rational Expectations Model for the Spanish economy) is a small open economy dynamic general equilibrium model in the vein of the New-Neoclassical-Keynesian synthesis models, with a strongly micro-founded system of equations. In the long run REMS behaves in accordance with the neoclassical growth model. In the short run, it incorporates nominal, real and financial frictions. Real frictions include adjustment costs in consumption (via habits in consumption and rule-of-thumb households) and investment into physical capital. Due to financial frictions, there is no perfect arbitrage between different types of assets. The model also allows for slow adjustment in wages and price rigidities, which are specified through a Calvo-type Phillips curve. All these modelling choices are fairly in line with other existing models for the Spanish economy. One valuable contribution of REMS to the renewed vintage of D(S)GE models attempting to feature the Spanish economy is the specification of the labour market according to the search paradigm, which is best suited to assess the impact of welfare policies on both the intensive and extensive margins of employment. The model's most valuable asset is the rigour of the analysis of the transmission channels linking policy action with economic outcomes.