Discussion of

Optimal Monetary Policy in an Estimated DSGE Model for Hungary by Kucsera, Jakab, Szil´agyi and Vil´agi Ulf S¨ oderstr¨ om Sveriges Riksbank and CEPR

September 2009

This paper I

Optimal monetary policy in an estimated model of a small open economy

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Estimated on Hungarian data, 1995–2007

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Compare optimal policy with estimated and optimized rules Main findings:

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Optimal policy very aggressive Large welfare costs of suboptimal policy Optimized rules fairly efficient, especially wage inflation rule No gain from including exchange rate in policy rule Monetary policy more aggressive in more open economy

Optimal policy similar to closed economies

Why is optimal policy so aggressive?

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Goes back to earlier literature

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Has the MNB been too “doveish”? Are central banks too timid? Many important features not modelled:

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Uncertainty about model specification Uncertainty about incoming data and shocks Financial stability

Perhaps central banks are doing the right thing. . . . . . but we need to work harder to understand their reality

Why are the welfare costs of suboptimal policy so large? I

Estimated rule equivalent to 10% reduction in SS consumption! Optimized rule equivalent to 4% reduction

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Schmitt-Groh´e and Uribe (2007): optimized policy rule equivalent to 0.005% reduction

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LOWW (2005): estimated rule 0.56% reduction, optimized rule 0.12%

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Because steady state distorted?

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Many frictions and shocks: which are more important?

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Is it because of openness?

Why are optimized rules so efficient?

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Main distortions: price and wage rigidities

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Optimal monetary policy simple: stabilize price and wage inflation

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But: partly because Calvo contracts

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Other models of nominal rigidities and labor market distortions?

Why not respond to exchange rate?

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Goes back to earlier literature

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Here: Imports used only for production, not consumption

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Open-economy distortions: sticky prices in exports

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Avoids important question: target domestic or CPI inflation?

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What if sticky import prices (imperfect passthrough)?

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What if imports in consumption?

Why is policy more aggressive in more open economy?

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Exporters shielded because of reexporting

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Monetary policy focuses on domestic producers

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So policy even more aggressive in closed economy?

Important issues in small open economies I

What’s the role of the exchange rate for monetary policy? I

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Often very small in DSGE models

How respond to imported inflation? I I I

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Need good model of the exchange rate. . .

What’s the role of foreign disturbances?

Accomodate or lean against? Depends on how sticky import prices are Satisfactory answer?

How deal with export demand shocks? I I I

Current problem for many economies What happens to potential output and inflationary pressures? How sensitive are exports to exchange rate movements?

Reflections on optimal policy in medium-scale models I

Many frictions, many shocks

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Many of these are shortcuts, and many are observationally equivalent to alternatives

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We know much about shortcuts that are innocuous to first order But different alternatives may have very different second-order (welfare) effects

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Labor supply v. Wage markup shocks Calvo v. Taylor contracts MIU v. CIA?

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Arbitrary choices can have large effects on results

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Need to reevaluate alternatives in smaller models

Wrapping up

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Interesting and policy-relevant exercise

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But interpret with care Most interesting directions:

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Why so large welfare costs? What is the role of openness for optimal policy? What is the role of the exchange rate in optimal policy?

Think about alternative models