Bayesian Estimation of a Small Open Economy New Keynesian DSGE-VAR Model: The Impact of Exchange Rate Smoothing in the Case of South Korea during the Global Financial Crisis

Abstract

South Korea was one of the Asian economies hit hardest by the global financial crisis, yet recovered remarkably quickly compared to most other countries, partially because of its flexible monetary policy. This paper seeks a quantitative answer to the following question: Did the Bank of Korea employ exchange rate smoothing in its inflation targeting framework, and if so, how much deeper would the recession have been without it? To answer this question, we compare two Bayesian estimations of a small open economy New Keynesian DSGE model under different interest rate rules, with and without exchange rate smoothing, and find evidence of exchange rate smoothing. The structural model is based on Gali and Monacelli's (2005) standard workhouse model, but we add external habit formation and incomplete exchange rate passthrough. We then generate priors for a VAR using the best specified DSGE model, and use it to forecast differences in output during the most intense year of the crisis (2008:Q4 - 2009:Q3). Counterfactual simulations show that rather than the actual outcome of a 0.96 percent growth rate in real GDP, the outturn would have been 0.29 percent growth, corresponding to an approximate difference in value of 6.5 billion USD in South Korean output, if the Bank of Korea did not employ exchange rate smoothing monetary policy.