Author's personal copy Estimating a small open economy DSGE model with indeterminacy: Evidence from China Tingguo Zheng a, b , Huiming Guo c, ⁎ a Wang Yanan Institute for Studies in Economics, Xiamen University, Xiamen, Fujian, 361005, China b Department of Statistics, Rutgers University, Piscataway, NJ 08854, USA c National Association of Financial Market Institutional Investors (NAFMII), Beijing, 100033, China abstract article info Article history: Accepted 2 January 2013 Available online xxxx JEL classification: C5 E4 E5 F4 Keywords: Small open economy DSGE model Indeterminacy Monetary policy Considering that monetary policy instability may cause indeterminacy of the macroeconomic equilibrium, this paper derives the boundary condition between determinacy and indeterminacy in a small open economy DSGE model, and then uses this model to investigate China's monetary policy and macroeconomic fluctua- tions under indeterminacy during the period from 1992 to 2011. The empirical results show that the nominal interest rate reacts not only to inflation and output gap, but also to the changes in RMB exchange rate. More- over, the indeterminacy in the macro-dynamics indicates the instability in China's monetary policy, and it stems from two sources, the sunspot shock and the indeterminate propagation of fundamental shocks. In ad- dition, we find that the monetary policy shock affects macroeconomic dynamics significantly in the short run, while in the long run, it only influences nominal variables, such as the inflation and the exchange rate, but not the real output. © 2013 Elsevier B.V. All rights reserved. 1. Introduction Over the last decades, economists, central bankers and financial market analysts have shown increasing interest in monetary policy analysis. 1 One of the most prominent studies is the well-known Taylor rule, which was proposed as a guideline to evaluate and describe cen- tral bank policy actions intuitively. As shown in Taylor (1993), the central bank could adjust the interest rate according to inflation devi- ation (the deviation of inflation rate from its target) and output gap (the deviation of real output from its potential value). From then on, economists extended the original rule to various Taylor-type rules and applied them to examine monetary policy reaction functions in different countries (Clarida et al., 1998, 2000; Taylor, 2001). However, amongst these single-equation models, they fail to establish a clear link between the conduct of monetary policy and the performance of the economy, which makes the model economy far away from the real world, and hence the relevant concluding remarks might be inac- curate and unreliable. Recently economists are increasingly making use of dynamic sto- chastic general equilibrium (DSGE) models for macroeconomic analy- sis and monetary policy evaluation in academic research, especially at central banks. For example, the European Central Bank uses the DSGE model developed by Smets and Wouters (2003) to analyze the econo- my of the Euro zone as a whole. In fact, compared to other structural models such as vector autoregression (VAR), structural VAR, and si- multaneous equation model, the DSGE model has three apparent ad- vantages: Firstly, it provides a theoretical discipline on the structure of the model economy, in which it relates the reduced-form parame- ters to the structural parameters, and connects the short-run dynam- ics with the long-run equilibrium; secondly, it shows a more suitable framework for analyzing social welfare and designing an optimal pol- icy, as the agents' utility in the economy can be taken as a measure of welfare explicitly; lastly, it makes use of the micro-founded model for monetary policy analysis more appropriately, i.e. less subject to the Lucas critique. Furthermore, as shown in An and Schorfheide (2007) and Chib and Ramamurthy (2010), no matter how complicated the DSGE model is, the standardized Bayesian method can be used to real- ize the model estimation quickly. Although a large fraction of DSGE models are assumed to a closed economy (Justiniano et al., 2010; Rabanal, 2007), more and more stud- ies have considered the open economy version of the DSGE model to Economic Modelling 31 (2013) 642–652 ⁎ Corresponding author at: 16/F, Financial Street Center, 9A Financial Street, Xicheng District, Beijing 100033, China. Tel.: +86 10 66539225; fax: +86 10 66539070. E-mail addresses: zhengtg@gmail.com (T. Zheng), guohuiming1203@gmail.com (H. Guo). 1 By now there is a large and growing amount of macroeconomist work on DSGE models from theoretical perspective and empirical methodology. This includes Lubik and Schorfheide (2003, 2004, 2007), Fernádez-Villaverde and Rubio-Ramírez (2005, 2007), and Farmer et al. (2010, 2011). Subsequently, DSGE models have been elaborat- ed by many central banks, such as Smets and Wouters (2003) for EMU, SIGMA for the US, BEQM for England, TOTEM for Canada, AINO for Finland, and so on. In addition, Belaygorod and Dueker (2009) is one of the successes in the financial industry. 0264-9993/$ – see front matter © 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.econmod.2013.01.002 Contents lists available at SciVerse ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod