AN ESTIMATED DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM MODEL FOR ESTONIA* Paolo Gelain and Dmitry Kulikov*   Working Papers of Eesti Pank No 5/2009

This paper presents an estimated open economy dynamic stochastic general equilibrium model for Estonia. The model is designed to highlight the main driving forces behind the Estonian business cycle and to understand how euro area economic shocks and its monetary policy affect the small open economy of Estonia. The model described in this paper is a two-area DSGE model incorporating New Keynesian features such as nominal price and wage rigidity, variable capital utilization, investment adjustment costs, as well as other typical features - both for the domestic and euro area part of the model. It is rich in structural shocks such as technology, consumption preference, mark-up, etc. The model is estimated by Bayesian techniques using a quarterly data sample that covers main macroeconomic aggregates of Estonia and the euro area. The ultimate goal of the new model is for it to be used in simulation exercises, policy advice and forecasting at the Bank of Estonia.
JEL Code: E4, E5
Key words: monetary policy, New Keynesian models, small open economy, Bayesian statistical inference

* The principal work on the model was completed during Paolo Gelain's stay as a visiting researcher at Eesti Pank from June to September 2008. We also wish to thank seminar participants at Eesti Pank and Stockholm School of Economics in Riga, as well as participants of the Annual Estonian Economic Association Meeting in Toila, SMYE Conference in Istanbul, and ECEE Conference in Tallinn for many helpful suggestions and comments about the paper. All remaining mistakes and omissions are our own.

Author's e-mail address: dmitry.kulikov@epbe.ee

The views expressed are those of the authors and do not necessarily represent the official views of Eesti Pank.

Contents

1. Introduction

2. An Overview of the EP DSGE Model

3. Key Equations: The Estonian Economy

3.1. Households

3.1.1. Labour Supply

3.2. Firms

3.2.1. Final Good Producers
3.2.2. Intermediate Good Producers

3.3. Importers
3.4. Exporters
3.5. Policies

3.5.1. Fiscal Policy
3.5.2. Monetary Policy

3.6. The Aggregate Resource Constraint
3.7. The Net Foreign Assets

4. Key Equations: Euro Area Economy

5. Data and Estimation

5.1. Bayesian Estimation Methodology
5.2. Data and Priors

6. Empirical Results

6.1. Estimated Posterior Distributions
6.2. Model Fit
6.3. Model Response to Structural Shocks
6.4. Variance Decomposition Analysis

7. Conclusion

8. Appendix

8.1. Relative Prices, Marginal Costs and the Real Exchange Rate
8.2. The Log-Linearized Model for Estonia
8.3. The Log-Linearized Model for the Euro Area
8.4. The Steady State

References

An Estimated Dynamic Stochastic General Equilibrium Model for Estonia, Working Papers of Eesti Pank No 5/2009 (PDF*)

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