Disinflation in Small Open and Closed Economies

under Imperfect Credibility

Oleksandr Faryna1 Magnus Jonsson2

Nadiia Shapovalenko1

1 National Bank of Ukraine

2 Sveriges Riksbank

October 10, 2023

NaUKMA

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Disclaimer: the views and opinions herein are those of the authors
and do not necessarily reflect the views of the National Bank of
Ukraine and Sveriges Riksbank

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Motivation

I Disinflation is often associated with short-term output losses

I Empirically measured by sacrifice ratio, see Ball (1994)
I In a number of papers Ascari and Ropele show that simple NK
models can be in line with empirical estimates of output losses
I Ascari and Ropele study closed economy (CE) - but many
countries going through disinflation episodes are small open
economies (SOE)
I For example, Ukraine, Romania, Hungary, Turkey
I No consensus in empirical literature on the role of openness
and how monetary policy should be implemented in a
disinflation scenario in SOE

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
What we do

I Evaluate differences in costs of disinflation in a SOE vs. CE

I A simple SOE and CE new Keynesian framework - main
friction price stickiness
I Central bank follows Taylor-type simple rules
I Costs measured by sacrifice ratio (SFR)

I How the central bank should implement a disinflation policy?

I Optimized simple disinflation rules - useful in illustrating how
monetary policy should differ between SOE and CE
I Inflation targets usually gradually implemented and imperfect
central bank credibility can be a concern

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Related literature

I Costs of disinflation theoretical: Ascari and Ropelo (2012a,

2012b and 2013)
I Costs of disinflation empirical: Ball (1994), Mazumder
(2014), Mankiw (1999)
I Economic model: Galı́ (2008), Adolfson et al. (2005), Galı́
and Monacelli (2005), and Monacelli (2005)
I Gradual implementation: Ascari and Ropelo (2013)
I Imperfect credibility: Ascari and Ropelo (2013), Erceg and
Levin (2003), Gibbs and Kulish (2015), Cogley at al. (2011),
Goodfriend and King (2004), Blinder et al. (2008)

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Model

I Monopolistic competition
I Sticky prices (with price indexation) domestic and importing
firms
I Small open economy - UIP condition

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Households

I Choose how much to work

I Choose how much to consume (domestic and foreign goods)
I Choose how much to save (domestic and foreign bonds)
X∞
U= β t U(Ct , Nt ) (1)
t=0
η
h 1 η−1 1 η−1 i η−1
Ct = (1 − α) η (CH,t ) η + α η (CF ,t ) η (2)
h i 1
Pt = (1 − α) (PH,t )1−η + α (PF ,t )1−η
1−η
(3)

(1 − α) - home bias
η - elasticity of substitution between domestic and foreign goods

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Firms
Continuum of producing and importing firms

I Producers hire labour to produce differentiated good

I Importers buy foreign homogeneous good and re-brand to
differentiated good
I Both have monopolistic power and are subject to Calvo
pricing frictions
I there is a probability θ of not being able to change the price
I non re-optimizing firms index prices to past inflation

 1−
1−
1− ∗
PH/F ,t = (1 − θ) P H/F ,t + θ PH/F ,t−1 Πt−1 (4)

 - elasticity of substitution between goods (same for domestic and

imported goods) - determines the mark-up

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Monetary Policy

I Monetary policy follows simple Taylor-type rule - policy rate

reacts on deviations of inflation from target, the output gap,
or other economic conditions, see Taylor (1993)
  φπ  φY
1 + Rt Πt Yt
= (5)
1 + R̄ Π̄t Ȳ

I Standard parameters φπ = 1.5 and φY = 0.125

I Standard Taylor rule may not be a useful guideline under all
circumstances, i.e., when introducing a new inflation target -
we will further discuss optimized simple disinflation rules

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Imperfect central bank credibility (1)

I So far, the main driving forces in the economy were agents’

forward-looking expectations
I Agents beliefs on CB’s policy and new long-run inflation target
are perfect
I Lower inflation in future is reflected in today’s decisions

I In real life, new CB’s policy can lack credibility

I Imperfect credibility - a plausible explanation of short-term

costs of disinflation, see Goodfriend and King (2005), Erceg
and Levin (2003), Gibbs and Kulish (2015), Cogley at al.
(2011)

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Imperfect central bank credibility (2)
Imperfect credibility as in Ascari and Ropele (2013)
 
Ẽt (Πt+1 ) = 1 − ωtcred Et (Πt+1 ) + ωtcred Π∗old (6)

where ωcred is probability that CB returns to old target; ωcred is

”1” (zero credibility) initially and then becomes ”0” (full
credibility) with the following low of motion

ωtcred = ρcred ωt−1

cred
(7)

New expectations are added to the benchmark model in:

I Phillips curve (in addition to Calvo price indexation)
I Fisher equation
I UIP condition (relevant for open economy)

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Calibration

To parameterize the benchmark model, we use standard values

from the literature

Parameter Description Value

α Openness 0.4
β Discount factor 1.02ˆ(-0.25)
φ Frisch elasticity 2
θH , θF Price stickiness - firms and importers 0.75 (4 quarters)
η Domestic/imported subst elasticity 6
1/ + 1 Price markup - firms and importers 20 percent
ρπ Taylor rule: Weight on inflation 1.5
ρY Taylor rule: Weight on output 0.5/4

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Measuring costs of disinflation

I Sacrifice Ratio (SFR) similar to Ascari (2012)

T 
Yt − Y ∗

1 X
SR = − , T = 12
πold − πT Y∗
t=0

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Standard Taylor rule: closed economy

Inflation (annual) Policy rate Real interest rate

5 8 3.5
4 5% 2% 3
3 6
2.5
2
1 4 2
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Output gap Hours worked gap Consumption gap
0 0
0

-1 -1 -0.5

-2 -2 -1
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

0.2 0.5 0
0
0 -0.5
-0.2
-0.4
-0.5 -1
-0.6
-0.8 -1 -1.5
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

Inflation target Closed economy

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Standard Taylor rule: closed vs. open

Inflation (annual) Policy rate Real interest rate

5 8 3.5
4 5% 2% 3
3 6
2.5
2
1 4 2
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Output gap Hours worked gap Consumption gap
0 0
0

-1 -1 -0.5

-2 -2 -1
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Real exchange rate gap Net export over GDP NFA over GDP
0.2 0.5 0
0
0 -0.5
-0.2
-0.4
-0.5 -1
-0.6
-0.8 -1 -1.5
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

Inflation target Closed economy Small open economy

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Standard Taylor rule: imperfect credibility

Inflation (annual) Policy rate Real interest rate

5 8 3.5
4 5% 2% 3
3 6
2.5
2
1 4 2
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Output gap Hours worked gap Consumption gap
0 0
0

-1 -1 -0.5

-2 -2 -1
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Real exchange rate gap Net export over GDP NFA over GDP
0.2 0.5 0
0
0 -0.5
-0.2
-0.4
-0.5 -1
-0.6
-0.8 -1 -1.5
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

Inflation target Closed economy Small open economy

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Disinflation under standard Taylor rule: SFR

Sacrifice ratio
CE SOE
Perfect credibility 0.73% 0.83%
Imperfect credibility 1.09% 1.15%

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Optimized simple disinflation rules

I Optimal Taylor-type disinflation rules in SOE and CE

 φπ  φY  φQ
1 + Rt Πt Yt Qt
= (8)
1 + R̄ Π̄t Ȳ Q̄
where φπ , φY , and φQ are parameters to be optimized
I Search for optimized parameter vector φ = [φπ ; φY ; φQ ] that
during the transition to the new inflation target solve

φ̃ = arg min L (9)

φ

where L is central bank loss function

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Optimized simple disinflation rules: Costs

ρπ ρY ρQ SFR

Perfect credibility
CE: perfect 2 0 x 0.91%
SOE: perfect 6.6 2.1 0 0.77%

Imperfect credibility
CE: imperfect 7.8 1.3 x 1.77%
SOE: imperfect 13.4 4.1 0 1.41%

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Optimized simple disinflation rules: Perfect credibility

Inflation (annual) Policy rate Real interest rate

5 10 5
5% 2%
4
4 8
3
3
6 2
2
1
4
1 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

Output gap Consumption gap Real exchange rate gap

0 0.5
0
0
-0.5
-1 -0.5
-1
-1
-2
-1.5 -1.5
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Inflation target Closed economy Small open economy

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Optimized simple disinflation rules: Imperfect credibility

Inflation (annual) Policy rate Real interest rate

5 10 5
5% 2%
4
4 8
3
3
6 2
2
1
4
1 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

Output gap Consumption gap Real exchange rate gap

0 0.5
0
-0.5 0

-1 -1 -0.5

-1.5 -1
-2
-2 -1.5
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Inflation target Closed economy Small open economy

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Gradual implementation under imperfect credibility

Inflation (annual) Output gap Real interest rate

5 0.5 4
4 5% 2%
Linear

0
3 2
-0.5
2
1 -1 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Inflation (annual) Output gap Real interest rate
5 0.5 4
Concave

4
0
3 2
-0.5
2
1 -1 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Inflation (annual) Output gap Real interest rate
5 0.5 4
Convex

4
0
3 2
-0.5
2
1 -1 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12

Inflation target Closed economy Small open economy

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies
Key Results

I Disinflation is generally more costly in SOE measured by SFR

under Taylor rule due to the real FX appreciation

I Imperfect credibility increases SR

I Optimized monetary policy puts higher weight on output in

SOE than CE to minimize output loss - notably no weight on
exchange rate stabilization

I A decreasing rate of reduction of the inflation target is

optimal - reduce target quickly initially and then more slowly

Faryna, Jonsson, Shapovalenko (2018) Disinflation in Small Open and Closed Economies