Foreign exchange policies in small open economies [electronic resource]

Over the past two decades, New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model has become a major macroeconomics tool for the purpose of policy analysis. However, the majority of literature has ignored emerging market countries which typically present more difficulties in modeling. Among those challenges, one of the most important is to model the exchange rate policy in developing countries. Typically, there are two different actions which central banks in developing countries adopt with respect to the exchange rate. The first one is exchange rate targeting, where the central bank manipulates its instruments, i.e. operational targets such as the policy interest rate, to achieve some intermediate target of the exchange rate. The second action is exchange rate intervention where the exchange rate is now an operational target instead of an intermediate one. Chapter 1 considers the question: `Does the State Bank of Vietnam respond to exchange rate movements when it sets the interest rate in the co-existence of multiple exchange rates?' To answer this, chapter 1 uses Bayesian methods to estimate a structural New Keynesian DSGE model for a small open economy where there are different exchange rates co-existing. The result shows strong evidence for the alternative hypothesis that Vietnamese central bank strongly reacts to exchange rate movements in its monetary policy formulation. The result is robust to various prior choices on structural parameters as well as to different specifications of the monetary policy rule. Furthermore, this result also holds when the Bayesian VAR-DSGE method is used instead of a simple Bayesian estimation technique. Chapter 2 considers exchange rate intervention as most central banks in emerging markets have directly and actively intervened in the FX market to stabilize the exchange rate (among other claimed objectives) and chapter 3 adds an extra layer of sterilization as central bank aims to mitigate negative impacts of capital inflow. The model introduces FX intervention as an independent central bank instrument in a New Keynesian DSGE small open economy model with a full-fledged banking sector. Central bank participates in the foreign exchange market to meet its objectives on reserve coverage and exchange rate. Main findings validate that the model dynamics under different exchange rate regimes are consistent with common thoughts about impacts of FX intervention and sterilization. In addition, it shows that an FX intervention policy tends to lower volatilities of key macro variables and stabilize them much faster than an FX targeting policy. Besides, full sterilization stabilizes the economy faster than no sterilization does, leading to lower volatilities for most macro variables and the difference in impacts between full and zero sterilization is more significant under a fixed crawling peg. Finally, welfare analysis shows that the `optimal' sterilization level decreases as consumption habit persistence falls.

Keywords: Economics
Advisor: Taylor John primary advisor. Thesis advisor
Amador Manuel (Manuel A.) advisor. Thesis advisor
Klenow Peter J. advisor. Thesis advisor