Wing Leong Teo

Estimated Dynamic Stochastic General Equilibrium Model of the Taiwanese Economy

In this paper, I estimate an open economy DSGE model for the Taiwanese economy. The model features multiple sources of real and nominal rigidities, including price and wage stickiness, investment and bond adjustment costs, as well as incomplete pass-through of exchange rates. Contrary to the usual practice in the literature, monetary policy is modeled as a money supply rule instead of an interest rate rule, to be consistent with the policy regime in Taiwan. The model is estimated using Bayesian techniques. The estimated model is used to characterize monetary policy in Taiwan and assess relative importance of various shocks and frictions in Taiwanese economy

Inventories, Inflation Dynamics, and the New Keynesian Phillips Curve

We introduce inventories into an otherwise standard New Keynesian model and study the implications for inflation dynamics. Inventory holdings are motivated as a means to generate sales for demand-constrained firms. We derive various representations of the New Keynesian Phillips curve with inventories and show that one of these specifications is observationally equivalent to the standard model with respect to the behavior of inflation when the model’s cross-equation restrictions are imposed. However, the driving variable in the New Keynesian Phillips curve – real marginal cost – is unobservable and has to be proxied by, for instance, unit labor costs. An alternative approach is to impute marginal cost by using the model’s optimality conditions. We show that the stock-sales ratio is linked to marginal cost. We also estimate these various specifications of the New Keynesian Phillips curve using GMM. We find that predictive power of the inventory-specification at best approaches that of the standard model, but does not improve upon it. We conclude that inventories do not play a role in explaining inflation dynamics within our New Keynesian Phillips curve framework.

Inventories and Optimal Monetary Policy

We introduce inventories into a standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to study the effect on the design of optimal monetary policy. The possibility of inventory investment changes the transmission mechanism in the model by decoupling production from final consumption. This allows for a higher degree of consumption smoothing since firms can add excess production to their inventory holdings. We consider both Ramsey optimal monetary policy and a monetary policy that maximizes consumer welfare over a set of simple interest rate feedback rules. We find that in contrast to a model without inventories, Ramsey-optimal monetary policy in a model with inventories deviates from complete inflation stabilization. In the standard model, nominal price rigidity is a deadweight loss on the economy, which an optimizing policymaker attempts to remove. With inventories, a planner can reduce consumption volatility and raise welfare by accumulating inventories and letting prices change as an equilibrating mechanism. We find also find that the application of simple rules comes very close to replicating Ramsey optimal outcomes.

Deep Habits in the New Keynesian Phillips Curve

We derive and estimate a New Keynesian Phillips curve (NKPC) in a model where consumers are assumed to have deep habits. Habits are deep in the sense that they apply to individual consumption goods instead of aggregate consumption. This alters the NKPC in a fundamental manner as it introduces expected and contemporaneous consumption growth as well as the expected marginal value of future demand as additional driving forces for inflation dynamics. We construct the driving process in the deep habits NKPC by using the models optimality conditions to impute time series for unobservable variables. The resulting series is considerably more volatile than unit labor cost. General Methods of Moments (GMM) estimation of the NKPC shows an improved fit and a much lower degree of indexation than in the standard NKPC. Our analysis also reveals that the crucial parameters for the performance of the deep habit NKPC are the habit parameter and the substitution elasticity between differentiated products. The results are broadly robust to alternative specifications.

Ramsey Taxes Meet Price Rigidity

‘Ramsey taxes’ are commodity taxes that minimize deadweight loss. Evidence has shown dramatic differences in the extent of price rigidity across goods: while the prices of some goods change frequently, the prices of other goods seldom change. This paper examines Ramsey taxes in the presence of heterogeneous price rigidity. We find that, to minimize deadweight loss, lower (higher) tax rates should be imposed on goods with rigid prices if their relative prices are too high (low) relative to the would‐be situation of no price stickiness. Intuitively, Ramsey taxes remedy the relative price distortion caused by the price rigidity of some goods. We calibrate our model to data from Taiwan and the USA, showing a significant cut in welfare cost if Ramsey rather than uniform taxes are applied.

Welfare Cost of Infaltion in a New Keynesian Model

We study the welfare cost of inflation in a new Keynesian dynamic stochastic general equilibrium model. Nominal prices and wages are subjected to Taylor‐style adjustments in the benchmark model. We find that the welfare cost of inflation in a new Keynesian dynamic stochastic general equilibrium model is much higher than its counterpart in a real business cycle model. We also find that the welfare cost of inflation increases linearly with the inflation rate with the introduction of monopolistic competition but rises faster as the inflation rate increases with the introduction of nominal rigidity. Alternative price and wage setting schemes, such as Rotemberg and Calvo‐style adjustments would yield welfare costs of moderate inflation that are 2–10 times higher.

Policy Externalities and Optimal Exchange Rate Regimes

In this paper, I explore the welfare implications of a small countrys exchange rate regime, for the small country itself, as well as for a large country, the currency of which the small country potentially pegs to. A two-country dynamic stochastic general equilibrium model is developed for the analysis. Floating exchange rate regimes are modeled as Taylortype interest rate rules, with different feedback coefficients on inflation and output. I show that, compared to a fixed exchange rate regime, both countries will be worse off if the small country adopts an interest rate rule with a large feedback coefficient on output and a small feedback coefficient on inflation. I also show that it is important for the small country not to respond to output fluctuations in its interest rate rule, as it will generate costly fluctuations of inflation. On the other hand, holding the feedback coefficient on output at zero, the feedback coefficient on inflation matters very little for the welfare of the small country, as long as it is greater than 1 to guarantee uniqueness of equilibrium.