3^rd course PhD student Ishuova Zh.Sh.

Al Farabi Kazakh National University

Forecasting and Monetary Policy Analysis in Kazakhstan’s economy

Most recent works in macroeconomics include the development and assessment of monetary models, adding imperfect competition and nominal rigidity to a dynamic stochastic general equilibrium structure, which has been a hallmark of the theory of real business cycle (RBC) for a long time. In the resulting models – the new Keynesian models are often mentioned – the change in monetary parameters, as a rule, has a non-zero impact on real variables. Monetary policy can thus become a potential tool of stabilization, as well as an independent source of economic fluctuations. It is no wonder that the study of characteristics of alternative rules of monetary policy (i.e. specifications: how the National Bank changes the parameters of monetary tools in response to a change in macroeconomic conditions) has recently been a fruitful area of research and is a natural application of the new generation of models.

In the present work, it has been prepared a small version of the small open economy model with unstable pricing, and this model was also used as a basis for analyzing the characteristics and macroeconomic consequences of the alternative modes of monetary policy. The application of an unstable pricing structure allows the detection of a greater dynamic effect of monetary policy than the structures comprised of one period models of extended pricing, which are common in modern literature on the open economy.

The most important thing, when compared to most existing works, in which monetary policy is presented as an assumption that some monetary aggregates follow the exogenous stochastic process, is that we model monetary policy as an endogenous process, with the short-term interest rate being a tool of this policy. It is for this reason that our structure allows us to model alternative monetary modes.

Theoretical basis differs from the theories of most works in that it models the small open economy as one in a continuum of infinitely small economies, constituting the world economy. Our assumptions on preferences and technologies, combined with the pricing structure of the Kalvo model and assumptions about the (complete) financial market, bring us to a structure that is easily processed, as well as simple and intuitively understood log-linearized conditions of equilibrium for the Small Open Economy. In fact, the last condition of the equilibrium can be brought to a first order condition, two equations of a dynamic system for (domestic) inflation and output jump (drop in output), whose structure is identical to the “workhorse” model of tough pricing in a closed economy, which is often used to analyze monetary policy, comprising the new Keynesian Phillips curve and the dynamic equation IS. Of course, as we will show below, in conditions of open economy equilibrium, factors depend on parameters, which are specific for an open economy (in our case, the degree of openness and interchangeability of various products), while the driving forces also include fluctuations in world output, which are taken as exogenous variables in the Small Open Economy. In the case of a closed economy, the two equations must be supplemented with the description of how the monetary policy is conducted in order to close the model.

Then we discuss the issue of well-being assessment of the alternative policy modes; can get a second order approximation for the consumer’s benefit, which can be used for the purposes of monetary policy, by parameterization of household preferences. In particular, we look at what results in utility logarithm and the singular elasticity of product substitution, manufactured in various countries. There have been demonstrated that optimal monetary policy requires a completely stabilized level of domestic prices.

The structure for the analysis of macroeconomic consequences and the relative level of well-being have constructed with the help of three simple rules of monetary policy for the small open economy. The two simple rules under consideration are classical Taylor’s rules. The first rule systematically responds to domestic inflation (i.e. inflation of prices for products on the domestic market), while applying the domestic interest rate, and while the second rule implies that CPI inflation is the variable to which the central bank responds. The third rule maintains the effective nominal exchange rate at the same level (prevents fluctuations).

This scientific work has shown that these modes may be ranked according to the nominal exchange rate and trade terms, from the point of view of their implied volatility. Thus, the policy of tough domestic inflation targeting, which can achieve simultaneous stabilization of output jump and domestic inflation in our structure, implies much greater volatility of the nominal exchange rate and trade terms than the one, which is achieved within the limits of the two Taylor’s rules and/or the maintenance of the exchange rate at the same level. The excessive smoothness of the nominal exchange rate, implied by this simple rule (concerning optimal monetary policy), when combined with the assumed inertia stagnation in nominal prices, prevents relative prices from being adjusted promptly enough in response to the change of relative efficiency shocks, which results in significant deviation from the first best allocation. In particular, CPI based on Taylor’s rule is used to achieve equilibrium dynamics, which allows us to characterize it as a hybrid combined mode between the domestic inflation based on Taylor’s rule and the maintenance of the exchange rate at the same level (the third rule).

The following activities were carried out as part of this research work:

- analysis of the theoretical basis for modeling general equilibrium in the economy;

- review of the dynamic stochastic general equilibrium models with exogenous variables of the external world, and identification of specific characteristics of the economy of the Republic of Kazakhstan;

- adequacy assessment of individual blocks of the dynamic stochastic general equilibrium model;

- development of the DSGE model of the economy of the Republic of Kazakhstan with exogenous dynamics of economic variables of the rest of the world;

- analysis of the results of the economic policy options in the Republic of Kazakhstan.