A Small Open Economy DSGE Model for Pakistan

Adnan Haider, Safdar Ullah Khan

Abstract


In recent years there has been a growing interest in
academics, international policy institutions and central banks1 in
developing small-to-medium, even large-scale, open economy macroeconomic
models called Dynamic Stochastic General Equilibrium (DSGE) models based
on new-Keynesian framework.2 The term DSGE was originally used by
Kydland and Prescott (1982) in their seminal contribution on Real
Business Cycle (RBC) model. The RBC model is based on neoclassical
framework with micro-founded optimisation behaviour of economic agents
with flexible prices. One of the critical assumptions of this model is
that fluctuations of real quantities are caused by real shock only; that
is, only stochastic technology or government spending shocks play their
role. Later research in DSGE models however included Keynesian short-run
macroeconomic features (called nominal rigidities), such as Calvo (1983)
type staggered pricing behaviour and Taylor (1980) type wage contracts.
Hence this new DSGE modeling framework labeled as new-neoclassical
synthesis or new-Keynesian modeling paradigm. 3 This new approach
combines micro-foundations of both households and firms optimisation
problems and with a large collection of both nominal and real
(price/wage) rigidities that provide plausible short-run dynamic
macroeconomic fluctuations with a fully articulated description of the
monetary policy transmission mechanism; see, for instance, Christiano,
et al. (2005) and Smets and Wouters (2003). The key advantage of modern
DSGE models, over traditional reduce form macroeconomic models, is that
the structural interpretation of their parameters allows to overcome the
famous Lucas critique (1976).4 Traditional models contained equations
linking variables of interest of explanatory factors such as economic
policy variables. One of the uses of these models was therefore to
examine how a change in economic policy affected these variables of
interest, other things being equal. In using DSGE models for practical
purposes and to recommend how central banks and policy institutions
should react to the short-run fluctuations, it is necessary to first
examine the possible sources,5 as well as to evaluate the degree of
nominal and real rigidities present in the economy. In advanced
economies, like US and EURO area, it is easy to determine the degree of
nominal and real rigidities as these economies are fully documented. In
developing economies like Pakistan, where most of economic activities
are un-documented (also labeled as informal economy, black economy, or
underground economy), it is very difficult to determine the exact degree
of nominal and real rigidities present in the economy. However, one can
approximate results using own judgments and through well defined survey
based methods

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DOI: https://doi.org/10.30541/v47i4IIpp.963-1008

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