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Hi there,

I am trying to support the results that I have with some economic intuition. I have a small open economy model and I want to examine the optimal response under a central bank's objective function that minimizes the variance of inflation and output gap. I shock the model with international inflation (or price) shock and I get the following response:


Real exchange rate (RER) = (nominal exchange rate * World Price)/Domestic price. Therefore, you would expect RER to increases and Yx (exports) to increase as well because world prices are higher. The results as you see, positive world inflation shock lead to lower RER and lower exports in this small open economy. Therefore, interest rate is lowered as an optimal policy response. Is this normal dynamic for a calibrated DSGE with optimal policy objective? This is the results and I am trying to justify it. Any take on this? Thanks!

Best,

Any comments on this dynamic? from a theoretical or an empirical view?

It seems that the appreciation of the exchange rate led to lower exports, this is intuitive .. but why did the world inflation shock cause the exchange rate to appreciate ? I guess I ll have to think about it more. Still, any suggestions to cite any good papers support this would be great. Thanks!

Sorry, but this is not my literature. I would recommend to do a thorough literature research. There must be dozens of papers looking at this.