a welfare evaluation of east asian monetary policy regimes under foreign output shock

7/27/2019 A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock

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A Welare Evaluation o East Asian MonetaryPolicy Regimes under Foreign Output Shock

Joseph D. Alba, Wai-Mun Chia, and Donghyun Park

No. 299 | February 2012

ADB EconomicsWorking Paper Series


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ADB Economics Working Paper Series No. 299

A Welare Evaluation o East Asian Monetary

Policy Regimes under Foreign Output Shock

Joseph D. Alba, Wai-Mun Chia, and Donghyun Park

February 2012

oseph . Alba is Associate rofessor, ivision of conomics, chool of umanities and ocial ciences,

anyang echnological niversity, ingapore. ai-Mun Chia is Assistant rofessor, ivision of conomics,

chool of umanities and ocial ciences, anyang echnological niversity. onghyun ark is rincipal

conomist, Macroeconomics and inance esearch ivision, conomics and esearch epartment,Asian evelopment Bank.


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Asian evelopment Bank

AB Avenue, Mandaluyong City

1550 Metro Manila, hilippines

www.adb.org/economics

2012 by Asian evelopment Bankebruary 2012

155-5252

ublication tock o. 1245

he views expressed in this paper

are those of the authors) and do not

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of the Asian evelopment Bank.

he AB conomics orking aper eries is a forum for stimulating discussion and

eliciting feedback on ongoing and recently completed research and policy studies

undertaken by the Asian evelopment Bank AB) staff, consultants, or resource

persons. he series deals with key economic and development problems, particularly

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methodological issues relating to project/program economic analysis, and statistical data

and measurement. he series aims to enhance the knowledge on Asias development

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availability of statistical data and development indicators for monitoring development

effectiveness.

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journals or chapters in books. he series is maintained by the conomics and esearch

epartment.

Printed on recycled paper


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Contents

Abstract v

. ntroduction 1

. ole of Monetary and xchange ate olicies

in Cushioning xternal hocks 4

. he Model 5

A. ouseholds 5

B. omestic irms

C. rice evel, erms of rade, and eal xchange ate 8

. Monetary olicy and xchange ate egimes 9

. elfare 9

. Model arameterization 10

. imulation esults and elfare 11

A. mpulse esponses under arious Monetary olicy egimes 11

B. elfare osses under arious Monetary olicies 1

C. ummary of imulation esults and elfare 19

. Conclusions 20

eferences 22


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Abstract

Adverse foreign output shocks have a sizable impact on the welfare of small

open economies. herefore, one of the key roles of monetary policy in those

economies is to minimize the welfare losses arising from such shocks. o

assess the welfare impact of external shocks under different monetary policy

regimes, we numerically solve and calculate the welfare loss function of a

G\QDPLFVWRFKDVWLFJHQHUDOHTXLOLEULXPPRGHOZLWKFRPSOHWHH[FKDQJHUDWHSDVV

WKURXJK:HQGWKDWFRQVXPHUSULFHLQGH[&3LQDWLRQWDUJHWLQJPLQLPL]HV

welfare losses for import-to-gross domestic product ) ratios from 0. to 0.9.

+RZHYHUZHOIDUHXQGHUWKHSHJJHGH[FKDQJHUDWHUHJLPHLVDOPRVWHTXLYDOHQWWR&3LQDWLRQWDUJHWLQJZKHQWKHLPSRUWWR*'3UDWLRLVZKLOHWKHGRPHVWLF

LQDWLRQWDUJHWLQJPLQLPL]HVZHOIDUHZKHQWKHLPSRUWWR*'3UDWLRLV:H

calibrate the model and derive welfare implications for eight ast Asian small

open economies.


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I. Introduction

Adverse foreign output shocks have a sizable impact on the macroeconomic performance

of small open economies. or example, the sharp recession of the advanced economies

GXHWRWKHJOREDOQDQFLDODQGHFRQRPLFFULVLVRIKDGDSURQRXQFHGHIIHFWRQ

the export and growth of ast Asias highly open, export-dependent economies. able 1

shows the cumulative contraction in real gross domestic product ) growth, relative

WRWUHQGRIWRIRU6LQJDSRUH7DLSHL&KLQDDQG+RQJRQJ&KLQDRU

WKHHSXEOLFRIRUHDDOD\VLDWKH3KLOLSSLQHVDQG7KDLODQGLWZDVWR

7DEOHFRQUPVWKDWWKHSULPDU\FKDQQHOIRUWKHWUDQVPLVVLRQRIWKHJOREDOFULVLVWR(DVW

Asia was the trade channel. he cumulative contraction of real export growth ranged

from 5.9 for ndonesia to 8.8 for hailand. t is not surprising that exports have

a large impact on the real of ast Asian economies in light of their heavy export

GHSHQGHQFH7KHUDWLRRIH[SRUWVWR*'3HYHQH[FHHGVLQ+RQJRQJ&KLQD

DOD\VLDDQG6LQJDSRUH

n light of their large effect on the macroeconomic outcomes of small open economies,

we can expect adverse foreign output shocks to have a large effect on their welfare.

herefore, one of the key roles of monetary policy in those economies is to minimize

the welfare losses arising from such shocks. able 1 shows the various monetary and

H[FKDQJHUDWHSROLF\UHJLPHVDGRSWHGE\(DVW$VLDQHFRQRPLHV+RQJRQJ&KLQDDQG

6LQJDSRUHKDYH[HGDQGSHJJHGH[FKDQJHUDWHUHJLPHVUHVSHFWLYHO\ZKLOHWKHHSXEOLF

RIRUHDQGRQHVLDWKH3KLOLSSLQHVDQG7KDLODQGKDYHDGRSWHGLQDWLRQWDUJHWLQJ

policies. Malaysia and aipei,China aim to do both, i.e., stabilize prices and intervene in

WKHIRUHLJQH[FKDQJHUDWHPDUNHWV(FRQRPLHVWKDWWDUJHWH[FKDQJHUDWHV+RQJRQJ

&KLQD6LQJDSRUHDQG7DLSHL&KLQDVKRZHGORZHUDYHUDJHFKDQJHVLQH[FKDQJHUDWHV

WKDQFRXQWULHVWKDWWDUJHWLQDWLRQQGRQHVLDWKHHSXEOLFRIRUHDWKH3KLOLSSLQHV

and hailand.1 he exception is Malaysia, which target both variables but experienced

DQDYHUDJHFKDQJHLQH[FKDQJHUDWHFORVHUWRLQDWLRQWDUJHWLQJFRXQWULHVQDGGLWLRQ

economies that target the exchange rate suffered a visibly larger cumulative decline in

UHDO*'3FRPSDUHGWRHFRQRPLHVWKDWWDUJHWLQDWLRQQDWLRQKDVEHHQJHQHUDOO\ORZIRU

all economies regardless of policy regimes.

2

1 Hong Kong, China; Singapore; and Taipei,China experienced the smallest average percentage change in exchangerates o 0.42%, 3.01%, and 3.98%, respectively. In contrast, Indonesia, the Republic o Korea, the Philippines, andThailand experienced an average percentage change in exchange rates in the range o 6.92% to 27.16%. Malaysia,which targets both exchange rate and ination but experienced an average change in exchange rate o 6.90%,which is closer to ination-targeting countries, is an exception.

2 In act, Indonesia and Thailand experienced deation.


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he central objective of this paper is to evaluate and compare the welfare impact of

H[WHUQDOVKRFNVXQGHUGLIIHUHQWPRQHWDU\DQGSROLF\UHJLPHVRUHVSHFLFDOO\ZHORRNDW

the welfare effects of foreign output shocks under seven different types of monetary and

H[FKDQJHUDWHSROLF\UHJLPHVD[HGRUSHJJHGH[FKDQJHUDWHUXOHDFRQVXPHUSULFH

LQGH[&3LQDWLRQWDUJHWLQJUXOHLQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJUXOHGRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDORXWSXWWDUJHWLQJDQGUHDORXWSXWWDUJHWLQJ

:HGRVRIRUHLJKWVPDOORSHQHFRQRPLHVLQ(DVW$VLD+RQJRQJ&KLQDQGRQHVLD

WKHHSXEOLFRIRUHDDOD\VLDWKH3KLOLSSLQHV6LQJDSRUH7DLSHL&KLQDDQG7KDLODQG

to assess and compare the extent to which each monetary and exchange rate policy

regime protects each of the eight economies from external shocks. ur welfare evaluation

is based on numerically solving and calculating the welfare loss function of a dynamic

VWRFKDVWLFJHQHUDOHTXLOLEULXP'6*(PRGHO:HFDOLEUDWHWKHPRGHOWRGHULYHZHOIDUH

implications for the eight countries.

ur paper is broadly similar with Alba, u, and Chia 2011) in its methodology. More

precisely, the two papers both use a model that is broadly based on Monacellis 2004) model of a small open economy. owever, Alba, u, and Chia 2011) examine the

impact of a negative foreign output shock on the volatility of macroeconomic variables

under alternative monetary and exchange rate policy regimes while we examine the

more fundamental, policy-relevant issue of the impact of such a shock on welfare. hile

macroeconomic volatility is important, it is a much less complete yardstick for evaluating

policy regimes than welfare. urthermore, the analysis of Alba, u, and Chia 2011) is

OLPLWHGWRWKUHHSROLF\UHJLPHVDQGIRXUFRXQWULHV7KHLUPDLQQGLQJLVWKDWVPDOORSHQ

HFRQRPLHVWKDWIROORZHLWKHU[HGH[FKDQJHUDWHRULQDWLRQWDUJHWLQJWHQGWRVWDELOL]H

UHDOH[FKDQJHUDWHDQGLQDWLRQEXWDWWKHH[SHQVHRIVXEVWDQWLDOYRODWLOLW\LQWKHUHDO

economy.

ur paper evaluates and compares the welfare losses of foreign output shocks under

alternative monetary and exchange rate policy regimes, and is thus able to inform us

about the relative desirability of different policy regimes. uch a welfare comparison is

useful for determining the optimal monetary and exchange rate policy regime in ast

Asias small open economies that are highly dependent on trade and hence vulnerable

WRIRUHLJQRXWSXWVKRFNV7KHSURQRXQFHGLPSDFWRIWKHUHFHVVLRQLQWKH

DGYDQFHGHFRQRPLHVLVDYLYLGUHPLQGHURIWKLVYXOQHUDELOLW\7KHFHQWUDOTXHVWLRQZH

seek to answer is the following which monetary and exchange rate policy regime leaves

ast Asian small open economies best off under external shocks? he rest of this paper

is organized as follows. ection explores the relationship between monetary and

H[FKDQJHUDWHSROLF\UHJLPHVDQGPDFURHFRQRPLFSHUIRUPDQFH6HFWLRQVSHFLHVRXUmodel. ection reports and discusses the main results, and ection concludes the

paper.

A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 3


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II. Role o Monetary and Exchange Rate Policies

in Cushioning External Shocks

he current crisis calls for a re-examination of macroeconomic policies in general andPRQHWDU\DQGH[FKDQJHUDWHSROLFLHVLQSDUWLFXODU6WLJOLW]DUJXHVWKDWLQDWLRQ

targeting is inappropriate, especially for emerging economies where energy and

commodities make up a larger share of the household budget compared to industrialized

countries. ther economists have suggested alternative monetary policy targets such as

nominal . n addition, Blanchard, ellAriccia, and Mauro 2010) argue that there

PD\EHDFDVHIRUWKHHPHUJLQJPDUNHWFHQWUDOEDQNHUVSUDFWLFHRIWDUJHWLQJLQDWLRQ

ZKLOHDOVRLQWHUYHQLQJLQWKHIRUHLJQH[FKDQJHPDUNHWV'HVSLWHWKHFULWLFLVPRILQDWLRQ

WDUJHWLQJGH&DOYDOKRLOKRQGVWKDWLQDWLRQWDUJHWLQJFRXQWULHVRXWSHUIRUPHG

QRQLQDWLRQWDUJHWLQJFRXQWULHVLQWKHSRVWSHULRG+HDUJXHVWKDWGXULQJWKHFULVLV

LQDWLRQWDUJHWLQJFRXQWULHVORZHUHGQRPLQDOLQWHUHVWUDWHVE\PRUHUHVXOWLQJLQHYHQ

larger real interest rate differentials and thus an even stronger monetary stimulus.

he theoretical and empirical literature also suggest a number of rationales for why

different monetary and exchange rate policy regimes may differ in their capacity to protect

FRXQWULHVIURPH[WHUQDOVKRFNVRUH[DPSOHLWLVRIWHQDUJXHGWKDWFRXQWULHVZLWKH[LEOH

exchange rate regimes can better insulate their economies from negative real shocks.4

n a study that is highly relevant to the transmission of foreign output shocks to ast Asia

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FRXQWULHVWRWHVWWKHK\SRWKHVLVWKDWH[LEOHH[FKDQJHUDWHVVHUYHDVDVKRFNDEVRUEHU

in small open economies, and mitigate the impact of external shocks more effectively

WKDQ[HGH[FKDQJHUDWHUHJLPHV+RIIPDQQGVWKDWFRXQWULHVZLWKPRUHH[LEOH

nominal exchange rates suffer smaller decline of real . his is due to real exchangerate depreciation, which improves external competitiveness and thus partly offsets the

negative impact of foreign output shocks.

n this paper, we evaluate and compare the welfare loss due to foreign output shocks in

ast Asias small open economies under alternative monetary and exchange rate policy

regimes. o do so, we develop a simple model that contains a goods market

characterized by imperfect competition and nominal rigidities.5 e numerically solve and

calculate the welfare loss function of the model under seven types of monetary

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WDUJHWLQJUXOHLQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJUXOHGRPHVWLFLQDWLRQWDUJHWLQJ

3 A debate on nominal GDP targeting among economists could be accessed online at http://economistsview.typepad.com/economistsview/2010/12/bernanke-and-mishkin-on-nominal-gdp-growth-targeting.html

4 Please reer to Friedman (1953), Mundell (1961), Poole (1970), Dornbusch (1980), Luer (1994), Obsteld andRogof (2000), Devereux (2004), Devereux, Lane, and Xu (2006), Broda (2004), Edwards and Levy Yeyati (2005), andHofman (2007).

5 There is a large and growing literature on open economy DSGE models that incorporate imperect competitionand nominal rigidities. Obsteld and Rogof (1995 and 1996) initiated open-economy macroeconomics researchbased on a synthesis o dynamic intertemporal approaches and sticky-price models o macroeconomicuctuations. This synthesis is known as the new open economy macroeconomics. Many economists have relied onthis new class o models to address many classical problems with new tools, and to generate new research ideasand questions.

4 | ADB Economics Working Paper Series No. 299


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aylor-type rule, nominal output targeting, and real output targeting. he open economy

framework makes it possible to examine the exchange rate channel in the transmission of

foreign output shocks to the domestic economy. e assume foreign output shocks to be

exogenous.

DQ\'6*(PRGHOVFRQVLGHURQO\WZRIDFWRULQSXWVQFRQWUDVWZHIROORZLPDQG

oungani 1992) and assume oil to be an input in a constant elasticity of substitution

C) production function where oil and capital are substitutes. ence, our model

captures an important stylized fact of global energy use, i.e., more developed economies

use less energy per unit of capital than less developed economies. n addition, it is

possible that exchange rate depreciation affects the price of imported oil which, in turn,

affects domestic output. e follow Monacelli 2004) and assume that capital is subject

to adjustment costs. ach monetary and exchange rate policy regime implicitly assigns

GLIIHUHQWZHLJKWVRQRYHUDOOLQDWLRQGRPHVWLFLQDWLRQWKHRXWSXWJDSDQGH[FKDQJHUDWH

in the interest rate rule. By explicitly evaluating and comparing the welfare loss due to

foreign output shocks under different types of monetary policy regimes, we address theextent to which different policy regimes mitigate the loss of welfare.

III. The Model

n this section, we lay out our model, which is broadly based on Monacellis 2004)

PRGHORIDVPDOORSHQHFRQRP\GHQWLFDODQGLQQLWHO\OLYHGKRXVHKROGVHDUQLQFRPH

IURPZRUNLQJIRUDQGUHQWLQJSK\VLFDOFDSLWDOWRGRPHVWLFUPV7KH\FRQVXPHEDVNHWVRI

differentiated domestic and foreign tradable goods.

A. Households

he domestic economy is populated by a continuum RILQQLWHO\OLYHGLGHQWLFDO

households. hey consume baskets of differentiated domestic and foreign goods that

are both tradable and indexed byj. he baskets of domestic and foreign varieties

of goods are associated with utility-based price indices P P j dj H t H t , , ( )( )

1

0

1 11--

and

P P j dj F t F t , , ( )( )

1

0

1 11--

, respectively, where the His the index for home and Ffor

foreign. he price indices are expressed in units of domestic currency.P jH t, ( ) and

P jF t, ( ) are prices of the individual domestic and foreign good j, respectively, where - ! 1is the elasticity of substitution between varieties within each category. he utility-based

consumer price index is given by P P Pt H t F t = + ( )( )

, ,

/1 1

1 1

1 .



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n each period, the households optimally allocate their expenditure on differentiated goods

within each category. he demand functions are

C jP j

PC C j

P j

PH t

H t

H t

H t F t

F t

F t

,

,

,

, ,

,

,

) )

; ) )

=

=

-

-

CF t, 1)

for alljgoods within the interval of 0 and 1, where the goods are produced

E\DFRQWLQXXPRIUPVDQGWKHUPVDUHRZQHGE\GRPHVWLFKRXVHKROGV

C C j dj H t H t , , ( )( )

- -

- -1

0

1 1

and C C j dj F t F t , , ( )( )

- -

- -1

0

11

are composite indices of

domestic and foreign goods, respectively. he households consume a C composite of

both home products CH) and foreign products CF)

C C Ct H t F t = + ( )( )

1 1 1 1

1

1, , 2)

where J0,1 is the share of home-produced goodsLQWRWDOFRQVXPSWLRQVRJrepresents the share of foreign-produced goods. U>1 is the elasticity of substitution

between domestic and foreign goods. nvestment composite index In In Int H t F t , ,,( ) hasan identical expression as consumption for simplicity. he optimal allocation of any

given expenditure between domestic and foreign goods yields the consumption demand

CP

PC C

P

PCH t

H t

t

t F t

F t

t

t,

,

,

,; )=

=

1

.

he representative domestic household maximizes the utility function over time

EC N

t t t t

t

1 1

0 1 1

+

=

+

)where V > 0 and M > 0, E is the discount factor and E ( )0 1, . 1/V is the intertemporalelasticity of substitution and M is the elasticity of labor substitution. Et is the expectation

operator. Ct is the consumption and Nt is the labor supply of the representative household

at time t.

he representative household holds securities denominated in domestic currency, rents

RXWLWVFDSLWDOWRWKHKRPHEDVHGPRQRSROLVWLFFRPSHWLWLYHUPDQGGHULYHVLQFRPHIURP

working for each time t. ence, the households budget constraint is written as

P C In B W N Z K Bt t t t t h

t t t t t t t

t

+( ) + ( ) = + + ++ ++ , 1 11 4)

where Bt1 is the portfolio of state contingent securities household holds at the end of

t, Qt t, 1 LVGHQHGE\RQDFHOOLDVWKHSULFLQJNHUQHORIVWDWHFRQWLQJHQWSRUWIROLR

HTXDOWRQ = + )h ht t1 where Monacelli lets h h ht t ,...., )0 be the history of events up toperiod tand the date 0 probability of observing htLVGHQHGDVdtwhere at the initial



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state d h )0 1 RQDFHOOLGHQHVWKHH[SHFWDWLRQRSHUDWRU E d h ht ht t

t

. ){} +

+1

1

. Wtis

the nominal wage, Zt is the nominal rental cost, and Wt represents the lump-sum transfer

payment.

ollowing Monacelli, capital accumulation is described as

K KIn

KKt t

t

t

t+ = ( ) +

1 1 G 5)

where G is the physical depreciation rate of capital. ) is an increasing and concave

function that assumes the adjustment cost in capital accumulation. ence, Intunits of

investment translate into In K K t t t( ) units of additional capital.

ith the arbitrage condition holding, it implies that

11

1Rt

t tht

= ++

Q ,and

11

1

1Rt

t th

t

tt

,= +

+

+

given that Rt and Rt

are expected returns in terms of domestic and foreign currency on

the bond portfolio.RQDFHOOLHTXDOL]HVWKHVHUHWXUQVWRJHW

t t t t t

thR R

t

, + + =+ 1

1

1

0

he rest of the world is assumed to have foreign households with similar preferences

as the home country so that foreign demand for home produced goodjis

C jP j

PC

P j

PH t

H t

H t

H t

H t

H t

,

,

,

,

,

,

( ) =( )

=

( )

- --

CH t,

where CP

PCH t

H t

t

t,

,

= ( )

1

.

B. Domestic Firms

abor, capital, and oil are inputs to production described by the constant elasticity of

substitution C production function. il is included in the C function following Alba,

u, and Chia 2011).7KHUHLVDFRQWLQXXPRIPRQRSROLVWLFDOO\FRPSHWLWLYHUPVZKLFK

are indexed by j[ ]0 1, . he C production function with constant return to scale hasWKHIROORZLQJVSHFLFDWLRQ

Y j A K j O j N j t t t t t ( ) = ( ) + ( ) ( ) ( ) ( )

1 1

1 1

1 )/

)

where 0 1 D , L ! 0 and X ! 0 . he elasticity of substitution between capital andRLOLVHTXDOWR 1/Q while labor share in production is given by D.

6 Rt = 1 + it where it is the nominal interest rate.7 For details, please reer to Alba, Su, and Chia (2011). Similarly, Backus and Crucini (2000) and Kim and Loungani

(1992) nest capital and oil as a CES unction within a Cobb-Douglas production unction while Rotemberg andWoodord (1996) and Blanchard and Gali (2007) consider oil and labor as inputs to production. Alternatively, Finn(2000) assumes oil and capital as complimentary. The complemetarity or substitutability o oil and capital areunresolved in empirical literature. For a survey o the literature, please reer to Apostolakis (1990). In addition,Bodenstein, Erceg, and Guerrieri (2008) consider oil as part o household consumption while Aoki (2001) examinesthe relationship between sector-specic supply shocks such as oil price shocks and ination uctuations.



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Monacelli 2004) follows Calvos 198) pricing. A fraction 1Ip RIDOOUPVDGXVWVWKHLUSULFHVUDQGRPO\ZKLOHWKHUHVWRIWKHUPVIp, do not adjust their prices. he parameter

Ip represents the degree of nominal rigidity whereby a largerIp LPSOLHVIHZHUUPV

adjusting their prices, causing a longer expected time between price adjustments. irms

IXWXUHSURWVDW t+kare affected by the choice of price at time tRQO\LIWKHUPGRHVQRWget another opportunity to adjust its price between tand t+k. Ip

k

LVWKHSUREDELOLW\RIDUP

not adjusting its price from tto t+k7KHGRPHVWLFUPjwill set price PH tNew

, to maximize the

SURWIXQFWLRQ

E P j MC j Y j tk

p

k

t t k H t

new

t kk

t k , ,+ +

=

+( ) ( ) ( )

0

)

subject to the domestic and foreign demand given byY jP j

PC Ct k

H t

new

H t k

H t k H t k ++

+ +( )

( )

+

,

,

, ,

-

where t t k, + LVWKHWLPHYDU\LQJSRUWLRQRIWKHUPVGLVFRXQWIDFWRU+HQFHWKHRSWLPDOpricing condition is

P j

E MC j Y j

H t

new

t

k

p

k

t t k t k t k k

,

,

( ) =

( ) ( )

+ + +

=

1

0

( )

+ +=

E Y jt k pk t t k t k k

,0

8)

7KHDERYHHTXDWLRQGHVFULEHVWKHG\QDPLFPDUNXSIRUSULFHVHWWLQJ:KHQWKHSULFH

signal Ip

HTXDOV]HURHTXDWLRQEHFRPHV P j MC H t

new

t, ( ) = ( )- - 1 . ith symmetric

HTXLOLEULXPWKHGRPHVWLFDJJUHJDWHSULFHLQGH[LV

P P PH t p H t p H t new

, , ,= + ( ) ( )

( )

1

11

1 1

1 9)

C. Price Level, Terms o Trade, and Real Exchange Rate

he nominal exchange rate Ht is the price of one unit of foreign currency in terms of

domestic currency. Assuming the law of one price holds, P PH t t H t , ,H and P PF t t F t , ,

H . he

terms of trade, StLVGHQHGDVWKHSULFHRIWKHLPSRUWHGJRRGUHODWLYHWRWKHSULFHRIWKH

domestic good S PP

PP

t

F t

H t

t F t

H t

=

,

,

,

,

H ). he real exchDQJHUDWHLVWKHQGHQHGDV H Ht

r t t

t

PP

.

or a small open economy, domestic price changes do not affect the foreign price level.

o without loss of generality, we assume that P PF t t, = , where the foreign price level

is determined by the prices of non-oil goods and oil. ence, it can be expressed as



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P P Pt NO t O t no no = ( ) ( ), ,

J J1

. or simplicity, we normalize PNO t, to one so the foreign non-oil

LQDWLRQSNO t,

LV]HUR7KHWRWDO&3LQDWLRQLVGHQHGDVS t t tP P ( )log 1 and theGRPHVWLFLQDWLRQLVGHQHGDV S H t H t H t P P, , ,log ( )1 .

D. Monetary Policy and Exchange Rate Regimes

ROORZLQJRQDFHOOLGHYLDWLRQVRILQDWLRQRXWSXWDQGQRPLQDOH[FKDQJHUDWH

from their long-run target have feedback effects on short-run movements of the nominal

interest rate target given by

11

1

+( ) =

iP

PYt

t

t

t ty

10)

where it LVWKHLQDWLRQWDUJHWDQG , y and

are weights assigned to the movements

RI&3LQDWLRQRXWSXWDQGQRPLQDOH[FKDQJHUDWHUHVSHFWLYHO\DWKHUWKDQ&3

LQDWLRQHTXDWLRQFRXOGEHPRGLHGWRFRQVLGHUGRPHVWLFLQDWLRQZKHUHLQDWLRQ

could be written as P PH t H t H

, , ( )1

, where HLVWKHZHLJKWRQGRPHVWLFLQDWLRQ7KH

actual short-run interest rate is determined based on the monetary authoritys desire to

smooth changes in the nominal interest rate

1 1 11

1+( ) = +( ) +( )

i i it t tF F

11)

he exogenous stochastic processes for the foreign output, foreign interest rate,

domestic technology, and nominal oil price can be summarized as

Y Yt t tyy exp= ( )1

, 1 1 1+( ) = +( ) ( )i it t tii

exp

, A At t taa= ( )1 exp and

P PO t O t t po

po

,

, exp= ( ) ( )1 , respectively.8

E. Welare

e analyze the impact of various monetary policy regimes based on social welfare loss

function minimized by the central banks. he function is based on the second-order

aylor expansion of the households utility around the steady state as in otemberg and

oodford 1998 and 1999) and oodford 200), and extended to small open economies

by Chung, ung, and ang 200) and ivino 2009). he social welfare loss function is

derived as in alsh 2010) and could be expressed as

^ `E S Of

: 2 2

00

( )flexiblet t t tt

W E y y 12)

8 The rst order conditions, the steady state and market equilibrium, and the log-linearized equations are availablerom the authors upon request.



17/31

where =

( ) ( )

+( )1

2 1 1

1 2U CCp

p p

,

=

( ) ( )

+( )+( )

1 1

1

p p

p, and

flexible

ty is obtained by setting the probability of nonadjustment in price, Mp, close to zero.e set the inverse of elasticity of intertemporal substitution, V, and the elasticity of

substitution between home and foreign produced goods, HTXDOWRIROORZLQJ*DOLDQG

RQDFHOOL7KH\VKRZWKDWXVLQJWKLVVSHFLFDWLRQWRJHWKHUZLWKWKHDVVXPSWLRQV

of purchasing power parity and uncovered interest parity, the combined effects of

PDUNHWSRZHUDQGWHUPVRIWUDGHGLVWRUWLRQVFRXOGEHRIIVHWVRWKDWXQGHUH[LEOHSULFH

HTXLOLEULXPGRPHVWLFLQDWLRQWDUJHWLQJLVWKHRSWLPDOPRQHWDU\SROLF\(TXDWLRQ

measures welfare loss as a second order approximation to the utility loss of the domestic

consumer resulting from deviations from optimal monetary policy. ollowing ucas 198),

DOWHUQDWLYHPRQHWDU\SROLFLHVDUHVSHFLHGLQWKHFRQWH[WRIDVLPSOH'6*(PRGHODQG

the welfare losses are compared to draw policy implications.

F. Model Parameterization

he model is solved numerically and parameterized following Monacelli 2004).9 he

marginal disutility of work effort M is set to . As common in the Calvo 198) pricing

models, the probability of price nonadjustment, I, is set at 0.5. he steady-state

markup, --HTXDOVWR7KHODERUVKDUHRIRXWSXWHTXDOV7KHHODVWLFLW\RI

investment rate to the price of capital KHTXDOV

he monetary policy regime parameters are set as follows he interest rate smoothing

parameter, F, is 0.5. ZHIRU[HGRUSHJJHGH[FKDQJHUDWHZKLOHZH = 0.1 for

H[LEOHH[FKDQJHUDWHQGHUWKHH[LEOHH[FKDQJHUDWHUHJLPHWKHFHQWUDOEDQNFRXOGFKRRVHWRWDUJHWRQO\&3LQDWLRQVRZS= 1.5 and ZyRURQO\GRPHVWLFLQDWLRQVXFK

that ZS+ = 1.5 and ZyRUFKRRVHWRIROORZWKH7D\ORUUXOHVRZS = 1.5 and Zy

or target nominal output and set ZS = 1.5 and Zy = 1.5 or real output and set ZS = 0 and

Zy7KHFHQWUDOEDQNFRXOGDOVRWDUJHW&3LQDWLRQDQGH[FKDQJHUDWHDQGVHW

ZS= 1.5, Zy = 0 and ZH = 0.8.

As in Alba, u, and Chia 2011), the parameters of the serial correlation of the oil price

shocks Uy), foreign interest rate Ui), foreign output Uy), and technology Ua ) are set

to 0.90. he degrees of the impact of oil price on the foreign price level JNOHTXDOV

IRUDSRVLWLYHRLOSULFHVKRFNDQGIRUDQHJDWLYHRLOSULFHVKRFN7KHVHUHHFW

the asymmetric effect of oil price shocks.10 hese asymmetric effects also imply thatDSRVLWLYHRLOSULFHVKRFNKDVVLJQLFDQWHIIHFWRQPDUJLQDOFRVWZKLOHDQHJDWLYHRLO

price shock has negligible effect on marginal cost. he share of capital relative to oil in

production L) is 0.90. he standard deviations from the steady state of oil price

Po

) of

9 The numerical solution o the model is described in Uhlig (1997).10 For example, Chen, Finney, and Lai (2005) nd empirical evidence that gasoline prices in the US respond quickly to

a crude oil price increase but not to a decrease.



18/31

foreign nominal interest rate i

) and of technology a) are set at 1. he standard

GHYLDWLRQRIIRUHLJQRXWSXWIURPWKHVWHDG\VWDWHLVVHWWRRYHURQHSHULRG

he inverse of the elasticity of substitution between oil and capital, X, is calculated

from the expression of the steady state of the oil to capital ratio as a function of

the parameters X,G,E, and L.11:HIROORZLPDQGRXQJDQLLQVHWWLQJWKH

depreciation rate, GHTXDOVWRDQGWKHGLVFRXQWUDWHEHTXDOVWR7KH

share of oil relative to capital stock, 1L), is 0.10. iven these parameter values, X is

FDOFXODWHGEDVHGRQDYHUDJHHQHUJ\WRFDSLWDOUDWLRRIIRUQGRQHVLDIRUWKH

3KLOLSSLQHVIRUDOD\VLDIRU7KDLODQGIRUWKHHSXEOLFRIRUHD

IRU6LQJDSRUHIRU+RQJRQJ&KLQDIRU7DLSHL&KLQDDQGIRUWKHQLWHG

tates ), which is our benchmark country. hese values are used to calculate X of 9.

IRUQGRQHVLDIRUWKH3KLOLSSLQHVIRUDOD\VLDIRU7KDLODQGIRUWKHHSXEOLF

RIRUHDIRU6LQJDSRUHIRU+RQJRQJ&KLQDIRU7DLSHL&KLQDDQG

for the .127KHHVWLPDWHVIRUWKH6DUHFRPSDUDEOHWRLPDQGRXQJDQLVVHWWLQJ

ofXHTXDOVWRDQGDQHODVWLFLW\RIVXEVWLWXWLRQRIIRUWKH6$VDSUR[\IRUWKH

SDUDPHWHURQWKHSURSRUWLRQRIIRUHLJQJRRGVLQWRWDOFRQVXPSWLRQ J), we use imports

over of ast Asian countries as shown in able 1.

IV. Simulation Results and Welare

n this section, we report and discuss our simulation results, including estimates ofwelfare losses under alternative monetary policy regimes.

A. Impulse Responses under Various Monetary Policy Regimes

7KHVLPXODWHGLPSXOVHUHVSRQVHVLQLJXUHVUHSUHVHQWWKHG\QDPLFUHVSRQVHVRI

UHDORXWSXWLQDWLRQWHUPVRIWUDGHQRPLQDOUDWHVDQGUHDOH[FKDQJHUDWHVXQGHUVHYHQ

PRQHWDU\SROLF\UHJLPHV[HGRUSHJJHGH[FKDQJHUDWHUHJLPHVWULFW&3LQDWLRQ

WDUJHWLQJH[FKDQJHUDWHDQG&3LQDWLRQWDUJHWLQJWKH7D\ORUUXOHVWULFWGRPHVWLF

LQDWLRQWDUJHWLQJQRPLQDO*'3WDUJHWLQJDQGUHDO*'3WDUJHWLQJ

11 The steady-state capitaloil ratio is given by

K

O

Z

( )

=

1, where

Z= +

11

, which is the steady-

state rental cost o capital. The details o the derivation are available rom the authors upon request.12 Data on energy use in kiloton o oil equivalent (KOE) and gross capital ormation are rom the World Economic

Indicators or Hong Kong, China; Indonesia; the Republic o Korea; Malaysia; Philippines; Singapore; and the US.Data or Taipei,China are rom the CEIC Database. We calculate energy use by multiplying energy use in KOE by theaverage price o a kiloton o crude oil in 2000 US dollars. We use the CPI to convert energy use in 2000 US dollarsto 1985 international dollars in relation to the US. Data on CPI and the price o crude oil are rom the InternationalFinancial Statistics online.



19/31

Figure 1: Impulse Responses to a Negative Shock in Foreign Output

Figure 5: Under Fixed/Pegged Exchange Rate

33

0.5

0.4

0.3

0.2

0.1

0

0.1

0.2

0.3

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33

Terms o trade Domestic ination

CPI ination Nominal exchange rate

Real exchange rate Output

Source: Authors' estimates.


Figure 5: Under CPI Infation Targeting

0.5

0.4

0.3

0.2

0.1

0

0.1

0.2

0.3

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33




CPI = consumer price index.




20/31


Figure 5: Under Exchange Rate and CPI Infation Targeting

0.5

0.4

0.3

0.2

0.1

0

0.1

0.2

0.3

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33




CPI = consumer price index.Source: Authors' estimates.


Figure 5: Under Taylor Rule

0.4

0.3

0.2

0.1

0

0.1

0.2

0.3

0.4

0.5

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33







21/31


Figure 5: with Domestic Infation Targeting

0.4

0.3

0.2

0.1

0

0.1

0.2

0.3

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33






Figure 5: with Nominal GDP Targeting

0.4

0.2

0

0.2

0.4

0.6

0.8

1

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33




CPI = consumer price index, GDP = gross domestic product.Source: Authors' estimates.



22/31


Figure 5: with Real GDP Targeting

0.2

0

0.2

0.4

0.6

0.8

1

1.2

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33




CPI = consumer price index, GDP = gross domestic product.Source: Authors' estimates.

$QHJDWLYHIRUHLJQRXWSXWVKRFNKDVWKHELJJHVWLPSDFWRQGRPHVWLFRXWSXWXQGHU[HGRU

SHJJHGH[FKDQJHUDWHUHJLPHIROORZHGE\&3LQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJ&3

LQDWLRQWDUJHWLQJGRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDO*'3WDUJHWLQJ

and the least under real targeting. or a 1 decline in foreign output, real output

GHFOLQHVIURPLWVVWHDG\VWDWHE\XQGHU[HGH[FKDQJHUDWHUHJLPHXQGHU

&3LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJXQGHU&3LQDWLRQWDUJHWLQJ

XQGHUGRPHVWLFLQDWLRQWDUJHWLQJXQGHU7D\ORUUXOHDQGXQGHUQRPLQDO

RXWSXWQGHUUHDORXWSXWWDUJHWLQJLWULVHVE\LQWKHUVWSHULRGEHIRUHGHFOLQLQJE\

0.08.

he mitigated effect on real output under real and nominal output targeting and to a

lesser extent, aylor-type rule, could be explained by the large and sharp depreciation

in the nominal exchange rate following a negative foreign output shock. n the period

following the 1 negative foreign output shock, nominal exchange rate depreciates

from the steady state value by 0.4 for real output targeting, 0.5 for nominal output

targeting, and 0.24 for aylor-type rule. n turn, the large exchange rate depreciation

LQFUHDVHVWKHSULFHVRIRLODQGRWKHULPSRUWVFDXVLQJKLJKHUWRWDO&3LQDWLRQLNHZLVH

H[SHFWDWLRQVRIKLJKHULQDWLRQDQGIXUWKHUGHSUHFLDWLRQUDLVHWKHQRPLQDOLQWHUHVWUDWH

he impact on the nominal interest rate is shown in igure 8 where a 1 negative

foreign output shock increases nominal interest rate by 0.41, 0.11, and 0.08 from

the steady state for nominal output targeting, real output targeting, and aylor-type rule,

respectively. n contrast, nominal exchange rate depreciates only by 0.08, 0.02,



23/31

DQGIRU&3LQDWLRQGRPHVWLFLQDWLRQDQG&3LQDWLRQFXPH[FKDQJHUDWH

WDUJHWLQJUHVSHFWLYHO\7KLVOHDGVWRDUHGXFWLRQRI&3LQDWLRQIURPLWVVWHDG\VWDWH

E\IRU&3LQDWLRQWDUJHWLQJIRUSHJJHGH[FKDQJHUDWHUHJLPHDQG&3

LQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJDQGIRUGRPHVWLFLQDWLRQWDUJHWLQJWZR

periods after the shock. ence, nominal interest rate in igure 8 shows a decline fromVWHDG\VWDWHYDOXHVRIDQGIRU&3LQDWLRQGRPHVWLFLQDWLRQ

DQG&3LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJUHVSHFWLYHO\7KHQRPLQDOLQWHUHVWUDWH

hardly changes under pegged exchange rate regime. he impulse responses clearly show

DWUDGHRIIEHWZHHQORZHURXWSXWYRODWLOLW\DQGKLJKHULQDWLRQDQGQRPLQDOLQWHUHVWUDWH

volatility.

Figure 8: Impulse Responses o Interest Rate to a Negative Foreign

Figure 5: Output Shock Under Various Monetary Policies

0.1

0.08

0.06

0.04

0.02

0

0.02

0.04

0.06

0.08

0.1

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33

Pegged exchange rate Taylor-type rule

CPI ination targeting Domestic ination targeting

CPI inationexchange rate targeting Nominal output targeting


B. Welare Losses under Various Monetary Policies

e examine the impact of various monetary policies after a negative foreign output

shock using a welfare loss function described in ection , and shown in able 2

with the model parameters of oil-to-capital ratio of 0.25 and import-to- ratio of 0.5

taken as average values for ast Asian countries. he results show from least to most

ZHOIDUHORVVHVDVFRPSDUHGZLWKWKHRSWLPDOPRQHWDU\SROLF\DUHDVIROORZV&3LQDWLRQ

WDUJHWLQJ&3LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJSHJJHGH[FKDQJHUDWHUHJLPH

GRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDORXWSXWWDUJHWLQJDQGUHDORXWSXW



24/31

WDUJHWLQJ:LWKFRPSOHWHSDVVWKURXJK&3LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUH

loss under negative foreign output shock.

Table 2: Welare Loss ater a Negative Foreign Output Shock

Table 2: under Dierent Monetary Policies

Monetary Policy

Weights in the Interest Rate Rule Welare

Loss H y

Fixed /pegged exchange rate regime 0 0 0 0.99 2.35

CPI ination targeting 1.5 0 0 0.1 0.71

Exchange rate and ination targeting 1.5 0 0 0.8 1.91

Taylor-type rule 1.5 0 0.5 0.1 10.13

Domestic ination targeting 0 1.5 0 0.1 3.69

Nominal output targeting 1.5 0 1.5 0.1 49.25

Real output targeting 0 0 1.5 0.1 122.14

CPI = consumer price index, GDP = gross domestic product.Note: Welare loss is calculated based on the average percentage o imports over real GDP o 50% or the six East Asian countries

excluding Hong Kong, China and Singapore, which have percentage imports over GDP o 172% and 191%, respectively. Theaverage oil-to-capital ratio is 0.25 and the average elasticity o substitution o oil-to-capital is 3.14, excluding the Philippinesand Indonesia, which have an average oil-to-capital (elasticity o substitution o oil or capital) o 0.58 (7.8) and 0.90 (9.3),respectively. In the model, the import to GDP is (1) equals 0.5 while the elasticity o substitution o oil and capital is . ,H, y, and are the weights on overall ination, domestic ination, output gap, and exchange rate in the interest rate

rule equation. 1 in which optimal monetary policy under exible price equilibrium is domestic ination targetingas in Gali and Monacelli (2005).


ince there are large variations in import-to- ratio among ast Asian countries, we

FRQGXFWVHQVLWLYLW\DQDO\VLVEDVHGRQWKLVUDWLRUHSUHVHQWHGE\WKHSDUDPHWHU

his is the proportion of import in household consumption in the model. able shows

the estimates of welfare losses due to a 1 negative output shock for various ratiosof import-to- given an oil-to-capital ratio of 0.25 under different monetary policy

UHJLPHV7KHUHVXOWVVKRZWKDWIRUDQHFRQRP\ZLWKLPSRUWWR*'3UDWLRRI&3LQDWLRQ

WDUJHWLQJSHJJHGH[FKDQJHUDWHUHJLPHDQGDFRPELQDWLRQRI&3LQDWLRQDQGH[FKDQJH

rate targeting minimize the welfare losses.

RUDQHFRQRP\ZLWKLPSRUWWR*'3UDWLRRIGRPHVWLFLQDWLRQWDUJHWLQJGHOLYHUV

WKHOHDVWZHOIDUHORVVIROORZHGE\&3LQDWLRQWDUJHWLQJDQGWKHQ7D\ORUW\SHUXOHRU

FRXQWULHVZLWKLPSRUWWR*'3UDWLRVRI&3LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVW

ZHOIDUHORVVRULPSRUWWR*'3RI&3LQDWLRQWDUJHWLQJH[FKDQJHUDWHSHJDQG

&3LQDWLRQFXPH[FKDQJHUDWHSHJKDYHHTXLYDOHQWZHOIDUHORVVHV+HQFHFRXQWULHV

ZLWKDODUJHLPSRUWFRPSRQHQWFRXOGFRQWUROLQDWLRQXVWDVZHOOE\WDUJHWLQJH[FKDQJHUDWHVVLQFHLPSRUWHGLQDWLRQPDNHVXSDODUJHSURSRUWLRQRIRYHUDOORU&3LQDWLRQ

hese results are consistent with the literature under complete exchange rate pass

WKURXJKQDUHODWLYHO\FORVHGHFRQRP\GRPHVWLFLQDWLRQWDUJHWLQJVWDELOL]HVGRPHVWLF

prices and output. As the level of opennessproxied by the import-to- ratiorises,

increasing the ratio of foreign goods in the consumption basket so that C targeting

stabilizes overall prices and output.1

13 Chung, Jung, and Yang (2007) note that the lower levels o openness could be less relevant with incompleteexchange rate pass through.



25/31

Table 3: Welare Loss ater a Negative Foreign Output Shock Under Dierent Monetary

Table 3: Policies and Various Values o Import over GDP

Imports

over GDP

Monetary Policy

Fixed/

PeggedExchange

Rate Regime

CPIInfation

Targeting

Exchange

Rate andInfation

Targeting

Taylor-type

Rule

DomesticInfation

Targeting

NominalIncome

Targeting

RealIncome

Targeting

1.0 0.44 0.44 0.44 55.65 10.04 246.11 693.19

0.9 0.57 0.37 0.51 42.18 8.56 187.02 515.26

0.7 1.53 0.51 1.22 22.37 5.91 101.58 265.77

0.5 2.35 0.71 1.91 10.13 3.69 49.25 122.14

0.3 2.33 0.78 1.97 3.47 1.06 19.92 47.48

0.1 1.42 0.61 1.28 0.64 0.53 5.60 13.56

CPI = consumer price index, GDP = gross domestic product.Note: We use import over GDP as a proxy or (1) in the model. The elasticity o oil-to-capital is set at 3.14 as in Table 2.

1 in which optimal monetary policy under exible price equilibrium is domestic ination targeting as in Gali andMonacelli (2005).


e also calibrate the model for a pair of economies based on their ratios of oil to capital

and of import to and calculate the welfare losses under various monetary policy

UHJLPHV7KHSDLUVRIHFRQRPLHVDUH+RQJRQJ&KLQDDQG6LQJDSRUHWKHHSXEOLFRI

RUHDDQG7DLSHL&KLQDDOD\VLDDQG7KDLODQGDQGQGRQHVLDDQGWKH3KLOLSSLQHV7KH

estimates of welfare losses under various monetary policy regimes are shown in able 4.

7KH\VKRZWKDWHLWKHU[HGSHJJHGH[FKDQJHUDWHUHJLPHVRU&3LQDWLRQWDUJHWLQJ

GHOLYHUWKHOHDVWZHOIDUHORVVIRU+RQJRQJ&KLQDDQG6LQJDSRUHQWKHRWKHUKDQG

&3LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUHORVVIRUQGRQHVLDWKHHSXEOLFRIRUHD

DOD\VLDWKH3KLOLSSLQHV7DLSHL&KLQDDQG7KDLODQG

Table 4: Welare Loss ater a Negative Foreign Output Shock under Dierent Monetary

Table 3: Policies Calibrated or Various East Asian Countries

Country

Monetary Policy

Fixed/

Peg

Exchange

Rate Regime

CPI

Infation

Targeting

Exchange

Rate and

Infation

Targeting

Taylor-

type

Rule

Domestic

Infation

Targeting

Nominal

Income

Targeting

Real

Income

Targeting

Hong Kong, China and Singapore 0.47 0.47 0.47 56.90 10.97 258.76 720.08

Korea, Rep. o and Taipei,China 2.44 0.77 2.02 5.98 1.87 29.93 79.34

Malaysia and Thailand 0.93 0.39 0.77 31.01 17.66 134.55 357.72

Indonesia and the Philippines 2.27 0.73 1.87 6.47 1.87 31.53 70.50

CPI = consumer price index, GDP = gross domestic product.Note: Hong Kong, China and Singapore have an average import over GDP o 1, and elasticity o substitution o 2.1. The Republic

o Korea and Taipei,China have an average import over GDP o 0.4 and an elasticity o substitution o oil and capital o 2.3.Malaysia and Thailand have an average import over GDP o 0.8 and an elasticity o substitution o oil and capital o 5.1.Indonesia and the Philippines have an average import over GDP o 0.4 and an elasticity o substitution o oil and capital o

8.5. 1 in which optimal monetary policy under exible price equilibrium is domestic ination targeting as in Galiand Monacelli (2005).




26/31

C. Summary o Simulation Results and Welare

Consistent with the empirical evidence documented by offman 200), the comparison

EHWZHHQUHVSRQVHVRIDOWHUQDWLYHPRQHWDU\SROLF\UHJLPHVVXJJHVWVWKDWLERWK[HG

H[FKDQJHUDWHUHJLPHDQGLQDWLRQWDUJHWLQJWHQGWRVWDELOL]HUHDOH[FKDQJHUDWHDQGLQDWLRQDWWKHH[SHQVHRIVXEVWDQWLDOLQVWDELOLW\LQWKHUHDOHFRQRP\LLWKHPLWLJDWHG

decline in real output under the aylor-type rule is explained by the large depreciation

RIQRPLQDODQGUHDOH[FKDQJHUDWHVDQGLLLLQDWLRQUDWHLVORZHVWXQGHU&3LQDWLRQ

targeting. n addition, the decline in output is smallest under nominal and real

targeting due to the higher rate of nominal and real exchange rate depreciation. owever,

ERWKRXWSXWWDUJHWLQJDOVROHGWRWKHZRUVWLQDWLRQRXWFRPH&RQVLVWHQWZLWKULHGPDQV

SUHGLFWLRQVORQJUXQGLIIHUHQFHVDFURVVUHJLPHVDUHQRWVLJQLFDQW

e also compare the welfare effects of the various monetary policy regimes as compared

ZLWKWKHRSWLPDOPRQHWDU\SROLF\XQGHUH[LEOHSULFHVXVLQJDTXDGUDWLFVRFLDOZHOIDUH

loss function. e show that with an average oil-to-capital ratio of 0.2 and import-to-UDWLRRI&3LQDWLRQWDUJHWLQJOHDGVWRWKHOHDVWZHOIDUHORVVIROORZHGE\LQDWLRQ

DQGH[FKDQJHUDWHWDUJHWLQJSHJJHGRU[HGH[FKDQJHUDWHUHJLPHGRPHVWLFLQDWLRQ

targeting, aylor-type rule, and nominal and real output targeting. he simulation results

VKRZWKDWDQHJDWLYHRXWSXWVKRFNFDXVHVWKHLQDWLRQUDWHDQGVXEVHTXHQWO\WKHQRPLQDO

LQWHUHVWUDWHWRGHFOLQHXQGHU&3LQDWLRQWDUJHWLQJQFRQWUDVWLQDWLRQULVHVXQGHU

aylor-type rule or nominal and real output targeting due to the large depreciation in the

QRPLQDODQGUHDOH[FKDQJHUDWHV7KHVHQGLQJVDUHFRQVLVWHQWZLWKGH&DUYDOKRLOKR

2010).

IWKHLPSRUWWR*'3UDWLRLVWKHZHOIDUHORVVRIFRXQWULHVZLWK&3LQDWLRQFXP

exchange rate targeting is comparable to countries with either pegged exchange rate or&3LQDWLRQWDUJHWLQJ+RZHYHULIWKHUDWLRLVEHWZHHQDQG&3LQDWLRQFXP

H[FKDQJHUDWHWDUJHWLQJLVRQO\VHFRQGEHVWWR&3LQDWLRQWDUJHWLQJIWKHUDWLRLVOHVV

WKDQLWLVZRUVHWKDQHLWKHU7D\ORUW\SHUXOHRU&3LQDWLRQRUGRPHVWLFLQDWLRQ

targeting.

ince ast Asian economies vary a lot with respect to the ratio of import-to-, ranging

IURPIRUQGRQHVLDWRPRUHWKDQIRU6LQJDSRUHDQG+RQJRQJ&KLQDZH

calculate the welfare loss of various monetary policy regimes for ratios between 10

DQG:HQGWKDWZLWKLPSRUWWR*'3UDWLRRIZHOIDUHORVVXQGHUWKH[HGRU

SHJJHGUHJLPHLVDOPRVWHTXLYDOHQWWRWKHZHOIDUHORVVXQGHU&3LQDWLRQWDUJHWLQJ7KLV

LVFRQVLVWHQWZLWKWKH&KRZDQGFHOLVQGLQJWKDW6LQJDSRUHVZHOIDUHORVVZLOO

QRWEHVLJQLFDQWO\OHVVLILWVZLWFKHVWRDPRUHH[LEOHH[FKDQJHUDWHV\VWHPDQGLQDWLRQ

WDUJHWLQJ(FRQRPLHVWKDWGHSHQGKHDYLO\RQLPSRUWVVXFKDV6LQJDSRUHDQG+RQJRQJ

&KLQDFDQPRGHUDWHLPSRUWHGLQDWLRQE\SHJJLQJWKHH[FKDQJHUDWHQFRQWUDVWIRU

LPSRUWVWR*'3UDWLRRIWKHGRPHVWLFLQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUH

loss as it also stabilizes output. hen import-to- ratio is between 0. and 0.9, C

LQDWLRQWDUJHWLQJGHOLYHUVWKHRXWFRPHZLWKWKHOHDVWZHOIDUHORVV



27/31

V. Conclusions

7KHJOREDOQDQFLDODQGHFRQRPLFFULVLVRIXQGHUOLQHGWKHYXOQHUDELOLW\RI

VPDOORSHQHFRQRPLHVWRDGYHUVHH[WHUQDORXWSXWVKRFNV$OWKRXJK(DVW$VLDVQDQFLDO

V\VWHPVZHUHODUJHO\LPPXQHIURPWKHJOREDOQDQFLDOLQVWDELOLW\WKHLUUHDOHFRQRPLHV

were severely affected by the deep recession of the advanced economies. his reignites

the debate about the appropriate monetary policy regime for a small open economy

subject to external shocks. he primary objective of our paper is to evaluate and compare

the welfare impact of external output shocks acting through the trade channel in eight

ast Asian countries with different monetary policy regimes. o do so, we use a simple

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exchange rate targeting, the aylor-type rule, and nominal and real output targeting.

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to foreign output shocks across monetary policy regimes. Compared to a aylor-type

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prevents the real exchange rate from depreciating. he negative impact of a fall in foreign

output is thus largely passed to the domestic economy. he mitigated decline in real

output under a aylor-type rule and nominal and real targeting is explained by a larger

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ur simulation results are also broadly consistent with the stylized facts of the ast

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smallest volatility in exchange rate but suffered the largest cumulative reduction in real

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targeting, experienced larger currency depreciation but suffered a smaller cumulative

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rate regimes give the least welfare losses in light of their high ratios of imports to .

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hilippines, and hailand since it offers the least welfare loss. his is consistent with the

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28/31

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At a broader level, our analysis can provide some guidance about monetary policy

regimes for small open economies. or such economies, which depend heavily onexports and trade for growth, the capacity of monetary policy to cushion the impact of

adverse external output shocks is one of the most important criteria for the appropriate

policy regime. he pronounced impact of the recession in the advanced economies on

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delivers the least welfare loss for most ast Asian small open economies except for those

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&3LQDWLRQWDUJHWLQJIRUVPDOORSHQHFRQRPLHVPD\EHWKDWLWSURWHFWVWKHPEHWWHUIURP

external output shocks.



29/31

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A Welare Evaluation o East Asian Monetary Policy Regimes under Foreign Output Shock

Joseph D. Alba, Wai-Mun Chia, and Donghyun Park assess the welare impact o external shocksunder diferent monetary policy regimes in East and Southeast Asia. To do so, they numericallysolve and calculate the welare loss unction o a dynamic stochastic general equilibrium (DSGE)model with complete exchange rate pass through. Their DSGE model simulation results suggestthat consumer price index ination targeting delivers the least welare losses or most small open

economies in East and Southeast Asia.

About the Asian Development Bank

ADBs vision is an Asia and Pacic region ree o poverty. Its mission is to help its developingmember countries reduce poverty and improve the quality o lie o their people. Despite theregions many successes, it remains home to two-thirds o the worlds poor: 1.8 billion peoplewho live on less than $2 a day, with 903 million struggling on less than $1.25 a day. ADB iscommitted to reducing poverty through inclusive economic growth, environmentallysustainable growth, and regional integration.

Based in Manila, ADB is owned by 67 members, including 48 rom the region. Its main

instruments or helping its developing member countries are policy dialogue, loans, equityinvestments, guarantees, grants, and technical assistance.

Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippineswww.adb.org/economics

a welfare evaluation of east asian monetary policy regimes under foreign output shock

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