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Quantitative Group Project

1 The model (equations and variables)

1.1 The model in brief

The model that you need to analyse is a modiÖed version of the New-Keynesian small open-economy (SOE) model in Justiniano and Preston (2010, henceforth JP), which in turn is based on the model in Monacelli (2005) and Gali and Monacelli (2005). Compared to the JP model, our modiÖed model assumes that the law of one price (LoP) holds for all imported retail goods and there is no price indexation for these imported goods. The foreign economy is also modeled di§erently than in the paper (see below for further details), although we still assume that the foreign economy is essentially a closed economy. The model is also extended to include a labor-supply shock, which could be used as a proxy for the supply-side disruption of the COVID-19 pandemic. There is also a cost-push shock that enters the domestic-price Phillips curve.

Aggregate áuctuations in the model are driven by 8 exogenous shocks. Five of these shocks are domestic shocks: preference (consumer spending), risk premium, monetary policy (interest rate), cost-push, and labor supply shocks. Three of the shocks are foreign or external shocks: foreign output, foreign ináation, and foreign interest rate shocks. These shocks a§ect the domestic economy through their ináuence on the foreign economyís out put, ináation, and nominal interest rate. The model can be derived from the ground up with micro-foundations, based on optimizing households, domestic Örms and importers, etc., resulting in a set of non-linear equations. We will instead work directly with the log-linearized equilibrium equations, listed below.