A Welfare Evaluation of East Asian Monetary

Policy Regimes under Foreign Output Shock

Joseph D. Alba, Wai-Mun Chia, and Donghyun Park
No. 299 | February 2012
ADB Economics
Working Paper Series
ADB Economics Working Paper Series No. 299
A Welfare Evaluation of East Asian Monetary
Policy Regimes under Foreign Output Shock
Joseph D. Alba, Wai-Mun Chia, and Donghyun Park
February 2012
Joseph D. Alba is Associate Professor, Division of Economics, School of Humanities and Social Sciences,
Nanyang Technological University, Singapore. Wai-Mun Chia is Assistant Professor, Division of Economics,
School of Humanities and Social Sciences, Nanyang Technological University. Donghyun Park is Principal
Economist, Macroeconomics and Finance Research Division, Economics and Research Department,
Asian Development Bank.
Asian Development Bank
6 ADB Avenue, Mandaluyong City
1550 Metro Manila, Philippines
www.adb.org/economics
2012 by Asian Development Bank
February 2012
ISSN 1655-5252
Publication Stock No. WPS124675
The views expressed in this paper
are those of the author(s) and do not
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of the Asian Development Bank.
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Contents
Abstract v
I. Introduction 1
II. Role of Monetary and Exchange Rate Policies
in Cushioning External Shocks 4
III. The Model 5
A. Households 5
B. Domestic Firms 7
C. Price Level, Terms of Trade, and Real Exchange Rate 8
D. Monetary Policy and Exchange Rate Regimes 9
E. Welfare 9
F. Model Parameterization 10
IV. Simulation Results and Welfare 11
A. Impulse Responses under Various Monetary Policy Regimes 11
B. Welfare Losses under Various Monetary Policies 16
C. Summary of Simulation Results and Welfare 19
V. Conclusions 20
References 22
Abstract
Adverse foreign output shocks have a sizable impact on the welfare of small
open economies. Therefore, one of the key roles of monetary policy in those
economies is to minimize the welfare losses arising from such shocks. To
assess the welfare impact of external shocks under different monetary policy
regimes, we numerically solve and calculate the welfare loss function of a
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WKURXJK:HQGWKDWFRQVXPHUSULFHLQGH[&3,LQDWLRQWDUJHWLQJPLQLPL]HV
welfare losses for import-to-gross domestic product (GDP) ratios from 0.3 to 0.9.
+RZHYHUZHOIDUHXQGHUWKHSHJJHGH[FKDQJHUDWHUHJLPHLVDOPRVWHTXLYDOHQW
WR&3,LQDWLRQWDUJHWLQJZKHQWKHLPSRUWWR*'3UDWLRLVZKLOHWKHGRPHVWLF
LQDWLRQWDUJHWLQJPLQLPL]HVZHOIDUHZKHQWKHLPSRUWWR*'3UDWLRLV:H
calibrate the model and derive welfare implications for eight East Asian small
open economies.
I. Introduction
Adverse foreign output shocks have a sizable impact on the macroeconomic performance
of small open economies. For example, the sharp recession of the advanced economies
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the export and growth of East Asias highly open, export-dependent economies. Table 1
shows the cumulative contraction in real gross domestic product (GDP) growth, relative
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WKH5HSXEOLFRI.RUHD0DOD\VLDWKH3KLOLSSLQHVDQG7KDLODQGLWZDVWR
7DEOHFRQUPVWKDWWKHSULPDU\FKDQQHOIRUWKHWUDQVPLVVLRQRIWKHJOREDOFULVLVWR(DVW
Asia was the trade channel. The cumulative contraction of real export growth ranged
from 5.96% for Indonesia to 38.78% for Thailand. It is not surprising that exports have
a large impact on the real GDP of East Asian economies in light of their heavy export
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0DOD\VLDDQG6LQJDSRUH
In light of their large effect on the macroeconomic outcomes of small open economies,
we can expect adverse foreign output shocks to have a large effect on their welfare.
Therefore, one of the key roles of monetary policy in those economies is to minimize
the welfare losses arising from such shocks. Table 1 shows the various monetary and
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6LQJDSRUHKDYH[HGDQGSHJJHGH[FKDQJHUDWHUHJLPHVUHVSHFWLYHO\ZKLOHWKH5HSXEOLF
RI.RUHD,QGRQHVLDWKH3KLOLSSLQHVDQG7KDLODQGKDYHDGRSWHGLQDWLRQWDUJHWLQJ
policies. Malaysia and Taipei,China aim to do both, i.e., stabilize prices and intervene in
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&KLQD6LQJDSRUHDQG7DLSHL&KLQDVKRZHGORZHUDYHUDJHFKDQJHVLQH[FKDQJHUDWHV
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and Thailand.
1
The exception is Malaysia, which target both variables but experienced
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economies that target the exchange rate suffered a visibly larger cumulative decline in
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all economies regardless of policy regimes.
2
1
Hong Kong, China; Singapore; and Taipei,China experienced the smallest average percentage change in exchange
rates of 0.42%, 3.01%, and 3.98%, respectively. In contrast, Indonesia, the Republic of Korea, the Philippines, and
Thailand experienced an average percentage change in exchange rates in the range of 6.92% to 27.16%. Malaysia,
which targets both exchange rate and infation but experienced an average change in exchange rate of 6.90%,
which is closer to infation-targeting countries, is an exception.
2
In fact, Indonesia and Thailand experienced defation.
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2 | ADB Economics Working Paper Series No. 299
The central objective of this paper is to evaluate and compare the welfare impact of
H[WHUQDOVKRFNVXQGHUGLIIHUHQWPRQHWDU\DQGSROLF\UHJLPHV0RUHVSHFLFDOO\ZHORRNDW
the welfare effects of foreign output shocks under seven different types of monetary and
H[FKDQJHUDWHSROLF\UHJLPHVD[HGRUSHJJHGH[FKDQJHUDWHUXOHDFRQVXPHUSULFH
LQGH[&3,LQDWLRQWDUJHWLQJUXOHLQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJUXOHGRPHVWLF
LQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDORXWSXWWDUJHWLQJDQGUHDORXWSXWWDUJHWLQJ
:HGRVRIRUHLJKWVPDOORSHQHFRQRPLHVLQ(DVW$VLD+RQJ.RQJ&KLQD,QGRQHVLD
WKH5HSXEOLFRI.RUHD0DOD\VLDWKH3KLOLSSLQHV6LQJDSRUH7DLSHL&KLQDDQG7KDLODQG
to assess and compare the extent to which each monetary and exchange rate policy
regime protects each of the eight economies from external shocks. Our welfare evaluation
is based on numerically solving and calculating the welfare loss function of a dynamic
VWRFKDVWLFJHQHUDOHTXLOLEULXP'6*(PRGHO:HFDOLEUDWHWKHPRGHOWRGHULYHZHOIDUH
implications for the eight countries.
Our paper is broadly similar with Alba, Su, and Chia (2011) in its methodology. More
precisely, the two papers both use a model that is broadly based on Monacellis (2004)
DSGE model of a small open economy. However, Alba, Su, and Chia (2011) examine the
impact of a negative foreign output shock on the volatility of macroeconomic variables
under alternative monetary and exchange rate policy regimes while we examine the
more fundamental, policy-relevant issue of the impact of such a shock on welfare. While
macroeconomic volatility is important, it is a much less complete yardstick for evaluating
policy regimes than welfare. Furthermore, the analysis of Alba, Su, and Chia (2011) is
OLPLWHGWRWKUHHSROLF\UHJLPHVDQGIRXUFRXQWULHV7KHLUPDLQQGLQJLVWKDWVPDOORSHQ
HFRQRPLHVWKDWIROORZHLWKHU[HGH[FKDQJHUDWHRULQDWLRQWDUJHWLQJWHQGWRVWDELOL]H
UHDOH[FKDQJHUDWHDQGLQDWLRQEXWDWWKHH[SHQVHRIVXEVWDQWLDOYRODWLOLW\LQWKHUHDO
economy.
Our paper evaluates and compares the welfare losses of foreign output shocks under
alternative monetary and exchange rate policy regimes, and is thus able to inform us
about the relative desirability of different policy regimes. Such a welfare comparison is
useful for determining the optimal monetary and exchange rate policy regime in East
Asias small open economies that are highly dependent on trade and hence vulnerable
WRIRUHLJQRXWSXWVKRFNV7KHSURQRXQFHGLPSDFWRIWKHUHFHVVLRQLQWKH
DGYDQFHGHFRQRPLHVLVDYLYLGUHPLQGHURIWKLVYXOQHUDELOLW\7KHFHQWUDOTXHVWLRQZH
seek to answer is the following: which monetary and exchange rate policy regime leaves
East Asian small open economies best off under external shocks? The rest of this paper
is organized as follows. Section II explores the relationship between monetary and
H[FKDQJHUDWHSROLF\UHJLPHVDQGPDFURHFRQRPLFSHUIRUPDQFH6HFWLRQ,,,VSHFLHVRXU
model. Section IV reports and discusses the main results, and Section V concludes the
paper.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 3
II. Role of Monetary and Exchange Rate Policies
in Cushioning External Shocks
The current crisis calls for a re-examination of macroeconomic policies in general and
PRQHWDU\DQGH[FKDQJHUDWHSROLFLHVLQSDUWLFXODU6WLJOLW]DUJXHVWKDWLQDWLRQ
targeting is inappropriate, especially for emerging economies where energy and
commodities make up a larger share of the household budget compared to industrialized
countries. Other economists have suggested alternative monetary policy targets such as
nominal GDP.
3
In addition, Blanchard, DellAriccia, and Mauro (2010) argue that there
PD\EHDFDVHIRUWKHHPHUJLQJPDUNHWFHQWUDOEDQNHUVSUDFWLFHRIWDUJHWLQJLQDWLRQ
ZKLOHDOVRLQWHUYHQLQJLQWKHIRUHLJQH[FKDQJHPDUNHWV'HVSLWHWKHFULWLFLVPRILQDWLRQ
WDUJHWLQJGH&DOYDOKR)LOKRQGVWKDWLQDWLRQWDUJHWLQJFRXQWULHVRXWSHUIRUPHG
QRQLQDWLRQWDUJHWLQJFRXQWULHVLQWKHSRVWSHULRG+HDUJXHVWKDWGXULQJWKHFULVLV
LQDWLRQWDUJHWLQJFRXQWULHVORZHUHGQRPLQDOLQWHUHVWUDWHVE\PRUHUHVXOWLQJLQHYHQ
larger real interest rate differentials and thus an even stronger monetary stimulus.
The theoretical and empirical literature also suggest a number of rationales for why
different monetary and exchange rate policy regimes may differ in their capacity to protect
FRXQWULHVIURPH[WHUQDOVKRFNV)RUH[DPSOHLWLVRIWHQDUJXHGWKDWFRXQWULHVZLWKH[LEOH
exchange rate regimes can better insulate their economies from negative real shocks.
4
In a study that is highly relevant to the transmission of foreign output shocks to East Asia
GXULQJWKHFULVLV+RIIPDQQXVHVGDWDIURPDVDPSOHRIGHYHORSLQJ
FRXQWULHVWRWHVWWKHK\SRWKHVLVWKDWH[LEOHH[FKDQJHUDWHVVHUYHDVDVKRFNDEVRUEHU
in small open economies, and mitigate the impact of external shocks more effectively
WKDQ[HGH[FKDQJHUDWHUHJLPHV+RIIPDQQGVWKDWFRXQWULHVZLWKPRUHH[LEOH
nominal exchange rates suffer smaller decline of real GDP. This is due to real exchange
rate depreciation, which improves external competitiveness and thus partly offsets the
negative impact of foreign output shocks.
In this paper, we evaluate and compare the welfare loss due to foreign output shocks in
East Asias small open economies under alternative monetary and exchange rate policy
regimes. To do so, we develop a simple DSGE model that contains a goods market
characterized by imperfect competition and nominal rigidities.
5
We numerically solve and
calculate the welfare loss function of the DSGE model under seven types of monetary
DQGH[FKDQJHUDWHSROLF\UHJLPHVD[HGRUSHJJHGH[FKDQJHUDWHUXOHD&3,LQDWLRQ
WDUJHWLQJUXOHLQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJUXOHGRPHVWLFLQDWLRQWDUJHWLQJ
3
A debate on nominal GDP targeting among economists could be accessed online at http://economistsview.
typepad.com/economistsview/2010/12/bernanke-and-mishkin-on-nominal-gdp-growth-targeting.html
4
Please refer to Friedman (1953), Mundell (1961), Poole (1970), Dornbusch (1980), Lufer (1994), Obstfeld and
Rogof (2000), Devereux (2004), Devereux, Lane, and Xu (2006), Broda (2004), Edwards and Levy Yeyati (2005), and
Hofman (2007).
5
There is a large and growing literature on open economy DSGE models that incorporate imperfect competition
and nominal rigidities. Obstfeld and Rogof (1995 and 1996) initiated open-economy macroeconomics research
based on a synthesis of dynamic intertemporal approaches and sticky-price models of macroeconomic
fuctuations. This synthesis is known as the new open economy macroeconomics. Many economists have relied on
this new class of models to address many classical problems with new tools, and to generate new research ideas
and questions.
4 | ADB Economics Working Paper Series No. 299
Taylor-type rule, nominal output targeting, and real output targeting. The open economy
framework makes it possible to examine the exchange rate channel in the transmission of
foreign output shocks to the domestic economy. We assume foreign output shocks to be
exogenous.
0DQ\'6*(PRGHOVFRQVLGHURQO\WZRIDFWRULQSXWV,QFRQWUDVWZHIROORZ.LPDQG
Loungani (1992) and assume oil to be an input in a constant elasticity of substitution
(CES) production function where oil and capital are substitutes. Hence, our model
captures an important stylized fact of global energy use, i.e., more developed economies
use less energy per unit of capital than less developed economies. In addition, it is
possible that exchange rate depreciation affects the price of imported oil which, in turn,
affects domestic output. We follow Monacelli (2004) and assume that capital is subject
to adjustment costs. Each monetary and exchange rate policy regime implicitly assigns
GLIIHUHQWZHLJKWVRQRYHUDOOLQDWLRQGRPHVWLFLQDWLRQWKHRXWSXWJDSDQGH[FKDQJHUDWH
in the interest rate rule. By explicitly evaluating and comparing the welfare loss due to
foreign output shocks under different types of monetary policy regimes, we address the
extent to which different policy regimes mitigate the loss of welfare.
III. The Model
In this section, we lay out our model, which is broadly based on Monacellis (2004) DSGE
PRGHORIDVPDOORSHQHFRQRP\,GHQWLFDODQGLQQLWHO\OLYHGKRXVHKROGVHDUQLQFRPH
IURPZRUNLQJIRUDQGUHQWLQJSK\VLFDOFDSLWDOWRGRPHVWLFUPV7KH\FRQVXPHEDVNHWVRI
differentiated domestic and foreign tradable goods.
A. Households
The domestic economy is populated by a continuum RILQQLWHO\OLYHGLGHQWLFDO
households. They consume baskets of differentiated domestic and foreign goods that
are both tradable and indexed by j. The baskets of domestic and foreign varieties
of goods are associated with utility-based price indices
P P j dj
H t H t , ,
( )
( )

1
0
1
11
0
0
and
P P j dj
F t F t , ,
( )
( )

1
0
1
11
0
0
, respectively, where the H is the index for home and F for
foreign. The price indices are expressed in units of domestic currency.
P j
H t ,
( )
and
P j
F t ,
( ) are prices of the individual domestic and foreign good j, respectively, where
0 >1
is the elasticity of substitution between varieties within each category. The utility-based
consumer price index is given by P P P
t H t F t
- ( ) ( )





, ,
/
1 1
1 1
1 .
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 5
In each period, the households optimally allocate their expenditure on differentiated goods
within each category. The demand functions are:
C j
P j
P
C C j
P j
P
H t
H t
H t
H t F t
F t
F t
,
,
,
, ,
,
,
( )
( )
; ( )
( )

0
C
F t ,
(1)
for all j goods within the interval of 0 and 1, where the goods are produced
E\DFRQWLQXXPRIUPVDQGWKHUPVDUHRZQHGE\GRPHVWLFKRXVHKROGV
C C j dj
H t H t , ,
( )
( )

0 0
0 0
1
0
1
1
and
C C j dj
F t F t , ,
( )
( )

0 0
0 0
1
0
1
1
are composite indices of
domestic and foreign goods, respectively. The households consume a CES composite of
both home products (C
H
) and foreign products (C
F
):
C C C
t H t F t
- ( )
( )







1 1
1
1
1
1
, ,
(2)
where e [0,1] is the share of home-produced goodsLQWRWDOFRQVXPSWLRQVR)
represents the share of foreign-produced goods. > 1 is the elasticity of substitution
between domestic and foreign goods. Investment composite index
In In In
t H t F t , ,
,
( ) has
an identical expression as consumption for simplicity. The optimal allocation of any
given expenditure between domestic and foreign goods yields the consumption demand
C
P
P
C C
P
P
C
H t
H t
t
t F t
F t
t
t ,
,
,
,
; ( )

1
.
The representative domestic household maximizes the utility function over time:
E
C N
t
t t t
t

1 1
0
1 1
-

(3)
where o > 0 and > 0, | is the discount factor and
| ( ) 0 1 ,
. 1/ o is the intertemporal
elasticity of substitution and is the elasticity of labor substitution. E
t
is the expectation
operator. C
t
is the consumption and N
t
is the labor supply of the representative household
at time t.
The representative household holds securities denominated in domestic currency, rents
RXWLWVFDSLWDOWRWKHKRPHEDVHGPRQRSROLVWLFFRPSHWLWLYHUPDQGGHULYHVLQFRPHIURP
working for each time t. Hence, the households budget constraint is written as:
P C In B WN Z K B
t t t t t
h
t t t t t t t
t
- ( ) - ( ) - - -
- -
-

, 1 1
1
(4)
where B
t -1
is the portfolio of state contingent securities household holds at the end of
t, v
t t , -1
LVGHQHGE\0RQDFHOOLDVWKHSULFLQJNHUQHORIVWDWHFRQWLQJHQWSRUWIROLR
HTXDOWRv
-
( ) h h
t t 1
where Monacelli lets h h h
t
t
( ,...., )
0
be the history of events up to
period t and the date 0 probability of observing h
t
LVGHQHGDVd
t
where at the initial
6 | ADB Economics Working Paper Series No. 299
state d h ( )
0
1 0RQDFHOOLGHQHVWKHH[SHFWDWLRQRSHUDWRU
E d h h
t
h
t t
t
. ( ) {
-

-
1
1
. W
t
is
the nominal wage, Z
t
is the nominal rental cost, and t
t
represents the lump-sum transfer
payment.
Following Monacelli, capital accumulation is described as:
K K
In
K
K
t t
t
t
t -
( ) -

1
1 o (5)
where o is the physical depreciation rate of capital. u(.) is an increasing and concave
function that assumes the adjustment cost in capital accumulation. Hence, In
t
units of
investment translate into In K K
t t t
( )
units of additional capital.
With the arbitrage condition holding, it implies that
1
1
1
R
t
t t
h
t

-
-

v
,
and
1
1
1
1
R
t
t t
h
t
t t
* ,

-
-
-

given that
R
t
and
R
t
*
are expected returns in terms of domestic and foreign currency on
the bond portfolio.
6
0RQDFHOOLHTXDOL]HVWKHVHUHWXUQVWRJHW

t t t t
t
t
h
R R
t
,
*
[ ]
-
-

-
1
1
1
0
The rest of the world is assumed to have foreign households with similar preferences
as the home country so that foreign demand for home produced good j is
C j
P j
P
C
P j
P
H t
H t
H t
H t
H t
H t
,
,
,
,
,
,

( )
( )

( )

0 00
C
H t ,

where C
P
P
C
H t
H t
t
t ,
,

( )

.

B. Domestic Firms
Labor, capital, and oil are inputs to production described by the constant elasticity of
substitution CES production function. Oil is included in the CES function following Alba,
Su, and Chia (2011).
7
7KHUHLVDFRQWLQXXPRIPRQRSROLVWLFDOO\FRPSHWLWLYHUPVZKLFK
are indexed by
j [ ] 0 1 , . The CES production function with constant return to scale has
WKHIROORZLQJVSHFLFDWLRQ
Y j A K j O j N j
t t t t t
( ) ( ) - ( ) ( )

( )

( )



1 1
1 1
1
( ) /
(6)
where
0 1 < < o
,
i > 0
and
u > 0
. The elasticity of substitution between capital and
RLOLVHTXDOWR 1/v while labor share in production is given by o.
6
R
t
= 1 + i
t
where i
t
is the nominal interest rate.
7
For details, please refer to Alba, Su, and Chia (2011). Similarly, Backus and Crucini (2000) and Kim and Loungani
(1992) nest capital and oil as a CES function within a Cobb-Douglas production function while Rotemberg and
Woodford (1996) and Blanchard and Gali (2007) consider oil and labor as inputs to production. Alternatively, Finn
(2000) assumes oil and capital as complimentary. The complemetarity or substitutability of oil and capital are
unresolved in empirical literature. For a survey of the literature, please refer to Apostolakis (1990). In addition,
Bodenstein, Erceg, and Guerrieri (2008) consider oil as part of household consumption while Aoki (2001) examines
the relationship between sector-specifc supply shocks such as oil price shocks and infation fuctuations.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 7
Monacelli (2004) follows Calvos (1983) pricing. A fraction
1-|
p
RIDOOUPVDGMXVWVWKHLU
SULFHVUDQGRPO\ZKLOHWKHUHVWRIWKHUPV|
p
, do not adjust their prices. The parameter
|
p
represents the degree of nominal rigidity whereby a larger |
p
LPSOLHVIHZHUUPV
adjusting their prices, causing a longer expected time between price adjustments. Firms
IXWXUHSURWVDWt+k are affected by the choice of price at time tRQO\LIWKHUPGRHVQRW
get another opportunity to adjust its price between t and t+k.
|
p
k
LVWKHSUREDELOLW\RIDUP
not adjusting its price from t to t+k7KHGRPHVWLFUPj will set price P
H t
New
,
to maximize the
SURWIXQFWLRQ
E P j MC j Y j
t
k
p
k
t t k H t
new
t k
k
t k

, , - -

-
( ) ( )

( )

0
(7)
subject to the domestic and foreign demand given by
Y j
P j
P
C C
t k
H t
new
H t k
H t k H t k -
-

- -

( )
( )

,
,
, ,
0
where
t t k , -
LVWKHWLPHYDU\LQJSRUWLRQRIWKHUPVGLVFRXQWIDFWRU+HQFHWKHRSWLPDO
pricing condition is:
P j
E MC j Y j
H t
new
t
k
p
k
t t k t k t k
k
,
,
( )

( ) ( )

- - -

1
0

( )

- -

E Y j
t
k
p
k
t t k t k
k

,
0
(8)
7KHDERYHHTXDWLRQGHVFULEHVWKHG\QDPLFPDUNXSIRUSULFHVHWWLQJ:KHQWKHSULFH
signal |
p
HTXDOV]HURHTXDWLRQEHFRPHV P j MC
H t
new
t ,
( ) ( ) 0 0 1 . With symmetric
HTXLOLEULXPWKHGRPHVWLFDJJUHJDWHSULFHLQGH[LV
P P P
H t p H t p H t
new
, , ,
-
( ) ( )

( )

1
1
1
11
1 (9)

C. Price Level, Terms of Trade, and Real Exchange Rate
The nominal exchange rate H
t
is the price of one unit of foreign currency in terms of
domestic currency. Assuming the law of one price holds, P P
H t t H t , ,

c and P P
F t t F t , ,

c . The
terms of trade, S
t
LVGHQHGDVWKHSULFHRIWKHLPSRUWHGJRRGUHODWLYHWRWKHSULFHRIWKH
domestic good (
S
P
P
P
P
t
F t
H t
t F t
H t

,
,
,
,
c
). The real exchDQJHUDWHLVWKHQGHQHGDV c
c
t
r t t
t
P
P

.
For a small open economy, domestic price changes do not affect the foreign price level.
So without loss of generality, we assume that
P P
F t t ,

, where the foreign price level

is determined by the prices of non-oil goods and oil. Hence, it can be expressed as
8 | ADB Economics Working Paper Series No. 299
P P P
t NO t O t
no no

( ) ( )
, ,
1
. For simplicity, we normalize P
NO t ,
-
to one so the foreign non-oil
LQDWLRQS
NO t ,
-
LV]HUR7KHWRWDO&3,LQDWLRQLVGHQHGDVS
t t t
P P ( )

log
1
and the
GRPHVWLFLQDWLRQLVGHQHGDVS
H t H t H t
P P
, , ,
log
( )
1
.
D. Monetary Policy and Exchange Rate Regimes
)ROORZLQJ0RQDFHOOLGHYLDWLRQVRILQDWLRQRXWSXWDQGQRPLQDOH[FKDQJHUDWH
from their long-run target have feedback effects on short-run movements of the nominal
interest rate target given by:
1
1
1
-
( )

i
P
P
Y
t
t
t
t t
y

(10)
where
i
t
LVWKHLQDWLRQWDUJHWDQG

,
y
and

are weights assigned to the movements

RI&3,LQDWLRQRXWSXWDQGQRPLQDOH[FKDQJHUDWHUHVSHFWLYHO\5DWKHUWKDQ&3,
LQDWLRQHTXDWLRQFRXOGEHPRGLHGWRFRQVLGHUGRPHVWLFLQDWLRQZKHUHLQDWLRQ
could be written as
P P
H t H t
H
, ,
( )
1

, where
H
LVWKHZHLJKWRQGRPHVWLFLQDWLRQ7KH
actual short-run interest rate is determined based on the monetary authoritys desire to
smooth changes in the nominal interest rate:
1 1 1
1
1
- ( ) -
( )
- ( )

i i i
t t t
_
_
(11)
The exogenous stochastic processes for the foreign output, foreign interest rate,
domestic technology, and nominal oil price can be summarized as:
Y Y
t t t
y
y
* *
*
exp
( )
1

,
1 1
1
-
( )
-
( ) ( )

i i
t t t
i
i
* * *
*
exp

,
A A
t t t
a
a

( )
1

exp
and
P P
O t O t t
po
po
,
*
,
*
exp
( ) ( )
1

, respectively.
8
E. Welfare
We analyze the impact of various monetary policy regimes based on social welfare loss
function minimized by the central banks. The function is based on the second-order
Taylor expansion of the households utility around the steady state as in Rotemberg and
Woodford (1998 and 1999) and Woodford (2003), and extended to small open economies
by Chung, Jung, and Yang (2007) and Divino (2009). The social welfare loss function is
derived as in Walsh (2010) and could be expressed as:
{ }
| t

=
= O +
_
2 2
0
0
( )
flexible
t t t t
t
W E y y (12)
8
The frst order conditions, the steady state and market equilibrium, and the log-linearized equations are available
from the authors upon request.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 9
where

( )

( )

-
( )

1
2 1 1
1 2
U C
C
p
p p

( )

( )

- ( )
- ( )
1 1
1
p p
p
, and

flexible
t
y is obtained by setting the probability of nonadjustment in price,
p
, close to zero.
We set the inverse of elasticity of intertemporal substitution, o, and the elasticity of
substitution between home and foreign produced goods, HTXDOWRIROORZLQJ*DOLDQG
0RQDFHOOL7KH\VKRZWKDWXVLQJWKLVVSHFLFDWLRQWRJHWKHUZLWKWKHDVVXPSWLRQV
of purchasing power parity and uncovered interest parity, the combined effects of
PDUNHWSRZHUDQGWHUPVRIWUDGHGLVWRUWLRQVFRXOGEHRIIVHWVRWKDWXQGHUH[LEOHSULFH
HTXLOLEULXPGRPHVWLFLQDWLRQWDUJHWLQJLVWKHRSWLPDOPRQHWDU\SROLF\(TXDWLRQ
measures welfare loss as a second order approximation to the utility loss of the domestic
consumer resulting from deviations from optimal monetary policy. Following Lucas (1987),
DOWHUQDWLYHPRQHWDU\SROLFLHVDUHVSHFLHGLQWKHFRQWH[WRIDVLPSOH'6*(PRGHODQG
the welfare losses are compared to draw policy implications.
F. Model Parameterization
The model is solved numerically and parameterized following Monacelli (2004).
9
The
marginal disutility of work effort is set to 3. As common in the Calvo (1983) pricing
models, the probability of price nonadjustment, |, is set at 0.75. The steady-state
markup, 0 / (0 HTXDOVWR7KHODERUVKDUHRIRXWSXWHTXDOV7KHHODVWLFLW\RI
investment rate to the price of capital q HTXDOV
The monetary policy regime parameters are set as follows: The interest rate smoothing
parameter, _, is 0.5. e
c
IRU[HGRUSHJJHGH[FKDQJHUDWHZKLOHe
c
= 0.1 for
H[LEOHH[FKDQJHUDWH8QGHUWKHH[LEOHH[FKDQJHUDWHUHJLPHWKHFHQWUDOEDQNFRXOG
FKRRVHWRWDUJHWRQO\&3,LQDWLRQVRe
t
= 1.5 and e
y
RURQO\GRPHVWLFLQDWLRQVXFK
that e
tH
= 1.5 and e
y
RUFKRRVHWRIROORZWKH7D\ORUUXOHVRe
t
= 1.5 and e
y

or target nominal output and set e

t
= 1.5 and e
y
= 1.5 or real output and set e
t
= 0 and
e
y
7KHFHQWUDOEDQNFRXOGDOVRWDUJHW&3,LQDWLRQDQGH[FKDQJHUDWHDQGVHW
e
t
= 1.5, e
y
= 0 and e
c
= 0.8.
As in Alba, Su, and Chia (2011), the parameters of the serial correlation of the oil price
shocks (
y*
), foreign interest rate (
i*
), foreign output (
y*
), and technology (
a
) are set
to 0.90. The degrees of the impact of oil price on the foreign price level (
NO
HTXDOV
IRUDSRVLWLYHRLOSULFHVKRFNDQGIRUDQHJDWLYHRLOSULFHVKRFN7KHVHUHHFW
the asymmetric effect of oil price shocks.
10
These asymmetric effects also imply that
DSRVLWLYHRLOSULFHVKRFNKDVVLJQLFDQWHIIHFWRQPDUJLQDOFRVWZKLOHDQHJDWLYHRLO
price shock has negligible effect on marginal cost. The share of capital relative to oil in
production (i) is 0.90. The standard deviations from the steady state of oil price (

P
o
-
) of
9
The numerical solution of the model is described in Uhlig (1997).
10
For example, Chen, Finney, and Lai (2005) fnd empirical evidence that gasoline prices in the US respond quickly to
a crude oil price increase but not to a decrease.
10 | ADB Economics Working Paper Series No. 299
foreign nominal interest rate (

i
*
) and of technology (

a
) are set at 1%. The standard
GHYLDWLRQRIIRUHLJQRXWSXWIURPWKHVWHDG\VWDWHLVVHWWRRYHURQHSHULRG
The inverse of the elasticity of substitution between oil and capital, u, is calculated
from the expression of the steady state of the oil to capital ratio as a function of
the parameters u, o, |, and i.
11
:HIROORZ.LPDQG/RXQJDQLLQVHWWLQJWKH
depreciation rate, o,HTXDOVWRDQGWKHGLVFRXQWUDWH|HTXDOVWR7KH
share of oil relative to capital stock, (1i), is 0.10. Given these parameter values, u is
FDOFXODWHGEDVHGRQDYHUDJHHQHUJ\WRFDSLWDOUDWLRRIIRU,QGRQHVLDIRUWKH
3KLOLSSLQHVIRU0DOD\VLDIRU7KDLODQGIRUWKH5HSXEOLFRI.RUHD
IRU6LQJDSRUHIRU+RQJ.RQJ&KLQDIRU7DLSHL&KLQDDQGIRUWKH8QLWHG
States (US), which is our benchmark country. These values are used to calculate u of 9.3
IRU,QGRQHVLDIRUWKH3KLOLSSLQHVIRU0DOD\VLDIRU7KDLODQGIRUWKH5HSXEOLF
RI.RUHDIRU6LQJDSRUHIRU+RQJ.RQJ&KLQDIRU7DLSHL&KLQDDQG
for the US.
12
7KHHVWLPDWHVIRUWKH86DUHFRPSDUDEOHWR.LPDQG/RXQJDQLVVHWWLQJ
of uHTXDOVWRDQGDQHODVWLFLW\RIVXEVWLWXWLRQRIIRUWKH86$VDSUR[\IRUWKH
SDUDPHWHURQWKHSURSRUWLRQRIIRUHLJQJRRGVLQWRWDOFRQVXPSWLRQ), we use imports
over GDP of East Asian countries as shown in Table 1.
IV. Simulation Results and Welfare
In this section, we report and discuss our simulation results, including estimates of
welfare losses under alternative monetary policy regimes.
A. Impulse Responses under Various Monetary Policy Regimes
7KHVLPXODWHGLPSXOVHUHVSRQVHVLQ)LJXUHVUHSUHVHQWWKHG\QDPLFUHVSRQVHVRI
UHDORXWSXWLQDWLRQWHUPVRIWUDGHQRPLQDOUDWHVDQGUHDOH[FKDQJHUDWHVXQGHUVHYHQ
PRQHWDU\SROLF\UHJLPHV[HGRUSHJJHGH[FKDQJHUDWHUHJLPHVWULFW&3,LQDWLRQ
WDUJHWLQJH[FKDQJHUDWHDQG&3,LQDWLRQWDUJHWLQJWKH7D\ORUUXOHVWULFWGRPHVWLF
LQDWLRQWDUJHWLQJQRPLQDO*'3WDUJHWLQJDQGUHDO*'3WDUJHWLQJ
11
The steady-state capitaloil ratio is given by
K
O
Z

( )

1
, where

Z -
1
1

, which is the steady-

state rental cost of capital. The details of the derivation are available from the authors upon request.
12
Data on energy use in kiloton of oil equivalent (KOE) and gross capital formation are from the World Economic
Indicators for Hong Kong, China; Indonesia; the Republic of Korea; Malaysia; Philippines; Singapore; and the US.
Data for Taipei,China are from the CEIC Database. We calculate energy use by multiplying energy use in KOE by the
average price of a kiloton of crude oil in 2000 US dollars. We use the CPI to convert energy use in 2000 US dollars
to 1985 international dollars in relation to the US. Data on CPI and the price of crude oil are from the International
Financial Statistics online.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 11
Figure 1: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under Fixed/Pegged Exchange Rate
33
0.5
0.4
0.3
0.2

0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output

Source: Authors' estimates.

Figure 2: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under CPI Infation Targeting
0.5
0.4
0.3
0.2

0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.
Source: Authors' estimates.
12 | ADB Economics Working Paper Series No. 299
Figure 3: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under Exchange Rate and CPI Infation Targeting
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.
Source: Authors' estimates.
Figure 4: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: Under Taylor Rule
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
0.4
0.5
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.
Source: Authors' estimates.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 13
Figure 5: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: with Domestic Infation Targeting
0.4
0.3
0.2

0.1
0
0.1
0.2
0.3
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output
CPI = consumer price index.
Source: Authors' estimates.
Figure 6: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: with Nominal GDP Targeting
0.4

0.2
0
0.2
0.4
0.6
0.8
1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output
CPI = consumer price index, GDP = gross domestic product.
Source: Authors' estimates.
14 | ADB Economics Working Paper Series No. 299
Figure 7: Impulse Responses to a Negative Shock in Foreign Output
Figure 5: with Real GDP Targeting
0.2
0
0.2
0.4
0.6
0.8
1
1.2
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Terms of trade Domestic infation
CPI infation Nominal exchange rate
Real exchange rate Output
CPI = consumer price index, GDP = gross domestic product.
Source: Authors' estimates.
$QHJDWLYHIRUHLJQRXWSXWVKRFNKDVWKHELJJHVWLPSDFWRQGRPHVWLFRXWSXWXQGHU[HGRU
SHJJHGH[FKDQJHUDWHUHJLPHIROORZHGE\&3,LQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJ&3,
LQDWLRQWDUJHWLQJGRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDO*'3WDUJHWLQJ
and the least under real GDP targeting. For a 1% decline in foreign output, real output
GHFOLQHVIURPLWVVWHDG\VWDWHE\XQGHU[HGH[FKDQJHUDWHUHJLPHXQGHU
&3,LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJXQGHU&3,LQDWLRQWDUJHWLQJ
XQGHUGRPHVWLFLQDWLRQWDUJHWLQJXQGHU7D\ORUUXOHDQGXQGHUQRPLQDO
RXWSXW8QGHUUHDORXWSXWWDUJHWLQJLWULVHVE\LQWKHUVWSHULRGEHIRUHGHFOLQLQJE\
0.08%.
The mitigated effect on real output under real and nominal output targeting and to a
lesser extent, Taylor-type rule, could be explained by the large and sharp depreciation
in the nominal exchange rate following a negative foreign output shock. In the period
following the 1% negative foreign output shock, nominal exchange rate depreciates
from the steady state value by 0.64% for real output targeting, 0.35% for nominal output
targeting, and 0.24% for Taylor-type rule. In turn, the large exchange rate depreciation
LQFUHDVHVWKHSULFHVRIRLODQGRWKHULPSRUWVFDXVLQJKLJKHUWRWDO&3,LQDWLRQ/LNHZLVH
H[SHFWDWLRQVRIKLJKHULQDWLRQDQGIXUWKHUGHSUHFLDWLRQUDLVHWKHQRPLQDOLQWHUHVWUDWH
The impact on the nominal interest rate is shown in Figure 8 where a 1% negative
foreign output shock increases nominal interest rate by 0.41%, 0.11%, and 0.08% from
the steady state for nominal output targeting, real output targeting, and Taylor-type rule,
respectively. In contrast, nominal exchange rate depreciates only by 0.08%, 0.02%,
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 15
DQGIRU&3,LQDWLRQGRPHVWLFLQDWLRQDQG&3,LQDWLRQFXPH[FKDQJHUDWH
WDUJHWLQJUHVSHFWLYHO\7KLVOHDGVWRDUHGXFWLRQRI&3,LQDWLRQIURPLWVVWHDG\VWDWH
E\IRU&3,LQDWLRQWDUJHWLQJIRUSHJJHGH[FKDQJHUDWHUHJLPHDQG&3,
LQDWLRQDQGH[FKDQJHUDWHWDUJHWLQJDQGIRUGRPHVWLFLQDWLRQWDUJHWLQJWZR
periods after the shock. Hence, nominal interest rate in Figure 8 shows a decline from
VWHDG\VWDWHYDOXHVRIDQGIRU&3,LQDWLRQGRPHVWLFLQDWLRQ
DQG&3,LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJUHVSHFWLYHO\7KHQRPLQDOLQWHUHVWUDWH
hardly changes under pegged exchange rate regime. The impulse responses clearly show
DWUDGHRIIEHWZHHQORZHURXWSXWYRODWLOLW\DQGKLJKHULQDWLRQDQGQRPLQDOLQWHUHVWUDWH
volatility.
Figure 8: Impulse Responses of Interest Rate to a Negative Foreign
Figure 5: Output Shock Under Various Monetary Policies
0.1
0.08
0.06
0.04

0.02
0
0.02
0.04
0.06
0.08
0.1
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Pegged exchange rate Taylor-type rule
CPI infation targeting Domestic infation targeting
CPI infationexchange rate targeting Nominal output targeting
CPI = consumer price index.
Source: Authors' estimates.
B. Welfare Losses under Various Monetary Policies
We examine the impact of various monetary policies after a negative foreign output
shock using a welfare loss function described in Section II, G and shown in Table 2
with the model parameters of oil-to-capital ratio of 0.25 and import-to-GDP ratio of 0.5
taken as average values for East Asian countries. The results show from least to most
ZHOIDUHORVVHVDVFRPSDUHGZLWKWKHRSWLPDOPRQHWDU\SROLF\DUHDVIROORZV&3,LQDWLRQ
WDUJHWLQJ&3,LQDWLRQFXPH[FKDQJHUDWHWDUJHWLQJSHJJHGH[FKDQJHUDWHUHJLPH
GRPHVWLFLQDWLRQWDUJHWLQJ7D\ORUW\SHUXOHQRPLQDORXWSXWWDUJHWLQJDQGUHDORXWSXW
16 | ADB Economics Working Paper Series No. 299
WDUJHWLQJ:LWKFRPSOHWHSDVVWKURXJK&3,LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUH
loss under negative foreign output shock.
Table 2: Welfare Loss after a Negative Foreign Output Shock
Table 2: under Diferent Monetary Policies
Monetary Policy
Weights in the Interest Rate Rule Welfare
Loss

Fixed /pegged exchange rate regime 0 0 0 0.99 2.35

CPI infation targeting 1.5 0 0 0.1 0.71
Exchange rate and infation targeting 1.5 0 0 0.8 1.91
Taylor-type rule 1.5 0 0.5 0.1 10.13
Domestic infation targeting 0 1.5 0 0.1 3.69
Nominal output targeting 1.5 0 1.5 0.1 49.25
Real output targeting 0 0 1.5 0.1 122.14
CPI = consumer price index, GDP = gross domestic product.
Note: Welfare loss is calculated based on the average percentage of imports over real GDP of 50% for the six East Asian countries
excluding Hong Kong, China and Singapore, which have percentage imports over GDP of 172% and 191%, respectively. The
average oil-to-capital ratio is 0.25 and the average elasticity of substitution of oil-to-capital is 3.14, excluding the Philippines
and Indonesia, which have an average oil-to-capital (elasticity of substitution of oil for capital) of 0.58 (7.8) and 0.90 (9.3),
respectively. In the model, the import to GDP is (1) equals 0.5 while the elasticity of substitution of oil and capital is .
,

H
,
y
, and

are the weights on overall infation, domestic infation, output gap, and exchange rate in the interest rate
rule equation.
1
in which optimal monetary policy under fexible price equilibrium is domestic infation targeting
as in Gali and Monacelli (2005).
Source: Authors' estimates.
Since there are large variations in import-to-GDP ratio among East Asian countries, we
FRQGXFWVHQVLWLYLW\DQDO\VLVEDVHGRQWKLVUDWLRUHSUHVHQWHGE\WKHSDUDPHWHU
This is the proportion of import in household consumption in the model. Table 3 shows
the estimates of welfare losses due to a 1% negative output shock for various ratios
of import-to-GDP given an oil-to-capital ratio of 0.25 under different monetary policy
UHJLPHV7KHUHVXOWVVKRZWKDWIRUDQHFRQRP\ZLWKLPSRUWWR*'3UDWLRRI&3,LQDWLRQ
WDUJHWLQJSHJJHGH[FKDQJHUDWHUHJLPHDQGDFRPELQDWLRQRI&3,LQDWLRQDQGH[FKDQJH
rate targeting minimize the welfare losses.
)RUDQHFRQRP\ZLWKLPSRUWWR*'3UDWLRRIGRPHVWLFLQDWLRQWDUJHWLQJGHOLYHUV
WKHOHDVWZHOIDUHORVVIROORZHGE\&3,LQDWLRQWDUJHWLQJDQGWKHQ7D\ORUW\SHUXOH)RU
FRXQWULHVZLWKLPSRUWWR*'3UDWLRVRI&3,LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVW
ZHOIDUHORVV)RULPSRUWWR*'3RI&3,LQDWLRQWDUJHWLQJH[FKDQJHUDWHSHJDQG
&3,LQDWLRQFXPH[FKDQJHUDWHSHJKDYHHTXLYDOHQWZHOIDUHORVVHV+HQFHFRXQWULHV
ZLWKDODUJHLPSRUWFRPSRQHQWFRXOGFRQWUROLQDWLRQMXVWDVZHOOE\WDUJHWLQJH[FKDQJH
UDWHVVLQFHLPSRUWHGLQDWLRQPDNHVXSDODUJHSURSRUWLRQRIRYHUDOORU&3,LQDWLRQ
These results are consistent with the literature under complete exchange rate pass
WKURXJK,QDUHODWLYHO\FORVHGHFRQRP\GRPHVWLFLQDWLRQWDUJHWLQJVWDELOL]HVGRPHVWLF
prices and output. As the level of opennessproxied by the import-to-GDP ratiorises,
increasing the ratio of foreign goods in the consumption basket so that CPI targeting
stabilizes overall prices and output.
13
13
Chung, Jung, and Yang (2007) note that the lower levels of openness could be less relevant with incomplete
exchange rate pass through.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 17
Table 3: Welfare Loss after a Negative Foreign Output Shock Under Diferent Monetary
Table 3: Policies and Various Values of Import over GDP
Imports
over GDP
Monetary Policy
Fixed/
Pegged
Exchange
Rate Regime
CPI
Infation
Targeting
Exchange
Rate and
Infation
Targeting
Taylor-
type
Rule
Domestic
Infation
Targeting
Nominal
Income
Targeting
Real
Income
Targeting
1.0 0.44 0.44 0.44 55.65 10.04 246.11 693.19
0.9 0.57 0.37 0.51 42.18 8.56 187.02 515.26
0.7 1.53 0.51 1.22 22.37 5.91 101.58 265.77
0.5 2.35 0.71 1.91 10.13 3.69 49.25 122.14
0.3 2.33 0.78 1.97 3.47 1.06 19.92 47.48
0.1 1.42 0.61 1.28 0.64 0.53 5.60 13.56
CPI = consumer price index, GDP = gross domestic product.
Note: We use import over GDP as a proxy for (1) in the model. The elasticity of oil-to-capital is set at 3.14 as in Table 2.
1 in which optimal monetary policy under fexible price equilibrium is domestic infation targeting as in Gali and
Monacelli (2005).
Source: Authors' estimates.
We also calibrate the model for a pair of economies based on their ratios of oil to capital
and of import to GDP and calculate the welfare losses under various monetary policy
UHJLPHV7KHSDLUVRIHFRQRPLHVDUH+RQJ.RQJ&KLQDDQG6LQJDSRUHWKH5HSXEOLFRI
.RUHDDQG7DLSHL&KLQD0DOD\VLDDQG7KDLODQGDQG,QGRQHVLDDQGWKH3KLOLSSLQHV7KH
estimates of welfare losses under various monetary policy regimes are shown in Table 4.
7KH\VKRZWKDWHLWKHU[HGSHJJHGH[FKDQJHUDWHUHJLPHVRU&3,LQDWLRQWDUJHWLQJ
GHOLYHUWKHOHDVWZHOIDUHORVVIRU+RQJ.RQJ&KLQDDQG6LQJDSRUH2QWKHRWKHUKDQG
&3,LQDWLRQWDUJHWLQJGHOLYHUVWKHOHDVWZHOIDUHORVVIRU,QGRQHVLDWKH5HSXEOLFRI.RUHD
0DOD\VLDWKH3KLOLSSLQHV7DLSHL&KLQDDQG7KDLODQG
Table 4: Welfare Loss after a Negative Foreign Output Shock under Diferent Monetary
Table 3: Policies Calibrated for Various East Asian Countries
Country
Monetary Policy
Fixed/
Peg
Exchange
Rate Regime
CPI
Infation
Targeting
Exchange
Rate and
Infation
Targeting
Taylor-
type
Rule
Domestic
Infation
Targeting
Nominal
Income
Targeting
Real
Income
Targeting
Hong Kong, China and Singapore 0.47 0.47 0.47 56.90 10.97 258.76 720.08
Korea, Rep. of and Taipei,China 2.44 0.77 2.02 5.98 1.87 29.93 79.34
Malaysia and Thailand 0.93 0.39 0.77 31.01 17.66 134.55 357.72
Indonesia and the Philippines 2.27 0.73 1.87 6.47 1.87 31.53 70.50
CPI = consumer price index, GDP = gross domestic product.
Note: Hong Kong, China and Singapore have an average import over GDP of 1, and elasticity of substitution of 2.1. The Republic
of Korea and Taipei,China have an average import over GDP of 0.4 and an elasticity of substitution of oil and capital of 2.3.
Malaysia and Thailand have an average import over GDP of 0.8 and an elasticity of substitution of oil and capital of 5.1.
Indonesia and the Philippines have an average import over GDP of 0.4 and an elasticity of substitution of oil and capital of
8.5.
1 in which optimal monetary policy under fexible price equilibrium is domestic infation targeting as in Gali
and Monacelli (2005).
Source: Authors' estimates.
18 | ADB Economics Working Paper Series No. 299
C. Summary of Simulation Results and Welfare
Consistent with the empirical evidence documented by Hoffman (2007), the comparison
EHWZHHQUHVSRQVHVRIDOWHUQDWLYHPRQHWDU\SROLF\UHJLPHVVXJJHVWVWKDWLERWK[HG
H[FKDQJHUDWHUHJLPHDQGLQDWLRQWDUJHWLQJWHQGWRVWDELOL]HUHDOH[FKDQJHUDWHDQG
LQDWLRQDWWKHH[SHQVHRIVXEVWDQWLDOLQVWDELOLW\LQWKHUHDOHFRQRP\LLWKHPLWLJDWHG
decline in real output under the Taylor-type rule is explained by the large depreciation
RIQRPLQDODQGUHDOH[FKDQJHUDWHVDQGLLLLQDWLRQUDWHLVORZHVWXQGHU&3,LQDWLRQ
targeting. In addition, the decline in output is smallest under nominal and real GDP
targeting due to the higher rate of nominal and real exchange rate depreciation. However,
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SUHGLFWLRQVORQJUXQGLIIHUHQFHVDFURVVUHJLPHVDUHQRWVLJQLFDQW
We also compare the welfare effects of the various monetary policy regimes as compared
ZLWKWKHRSWLPDOPRQHWDU\SROLF\XQGHUH[LEOHSULFHVXVLQJDTXDGUDWLFVRFLDOZHOIDUH
loss function. We show that with an average oil-to-capital ratio of 0.27 and import-to-GDP
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DQGH[FKDQJHUDWHWDUJHWLQJSHJJHGRU[HGH[FKDQJHUDWHUHJLPHGRPHVWLFLQDWLRQ
targeting, Taylor-type rule, and nominal and real output targeting. The simulation results
VKRZWKDWDQHJDWLYHRXWSXWVKRFNFDXVHVWKHLQDWLRQUDWHDQGVXEVHTXHQWO\WKHQRPLQDO
LQWHUHVWUDWHWRGHFOLQHXQGHU&3,LQDWLRQWDUJHWLQJ,QFRQWUDVWLQDWLRQULVHVXQGHU
Taylor-type rule or nominal and real output targeting due to the large depreciation in the
QRPLQDODQGUHDOH[FKDQJHUDWHV7KHVHQGLQJVDUHFRQVLVWHQWZLWKGH&DUYDOKR)LOKR
(2010).
,IWKHLPSRUWWR*'3UDWLRLVWKHZHOIDUHORVVRIFRXQWULHVZLWK&3,LQDWLRQFXP
exchange rate targeting is comparable to countries with either pegged exchange rate or
&3,LQDWLRQWDUJHWLQJ+RZHYHULIWKHUDWLRLVEHWZHHQDQG&3,LQDWLRQFXP
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WKDQLWLVZRUVHWKDQHLWKHU7D\ORUW\SHUXOHRU&3,LQDWLRQRUGRPHVWLFLQDWLRQ
targeting.
Since East Asian economies vary a lot with respect to the ratio of import-to-GDP, ranging
IURPIRU,QGRQHVLDWRPRUHWKDQIRU6LQJDSRUHDQG+RQJ.RQJ&KLQDZH
calculate the welfare loss of various monetary policy regimes for ratios between 10%
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SHJJHGUHJLPHLVDOPRVWHTXLYDOHQWWRWKHZHOIDUHORVVXQGHU&3,LQDWLRQWDUJHWLQJ7KLV
LVFRQVLVWHQWZLWKWKH&KRZDQG0F1HOLVQGLQJWKDW6LQJDSRUHVZHOIDUHORVVZLOO
QRWEHVLJQLFDQWO\OHVVLILWVZLWFKHVWRDPRUHH[LEOHH[FKDQJHUDWHV\VWHPDQGLQDWLRQ
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loss as it also stabilizes output. When import-to-GDP ratio is between 0.3 and 0.9, CPI
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A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 19
V. Conclusions
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were severely affected by the deep recession of the advanced economies. This reignites
the debate about the appropriate monetary policy regime for a small open economy
subject to external shocks. The primary objective of our paper is to evaluate and compare
the welfare impact of external output shocks acting through the trade channel in eight
East Asian countries with different monetary policy regimes. To do so, we use a simple
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exchange rate targeting, the Taylor-type rule, and nominal and real output targeting.
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to foreign output shocks across monetary policy regimes. Compared to a Taylor-type
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prevents the real exchange rate from depreciating. The negative impact of a fall in foreign
output is thus largely passed to the domestic economy. The mitigated decline in real
output under a Taylor-type rule and nominal and real targeting is explained by a larger
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Our simulation results are also broadly consistent with the stylized facts of the East
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smallest volatility in exchange rate but suffered the largest cumulative reduction in real
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targeting, experienced larger currency depreciation but suffered a smaller cumulative
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rate regimes give the least welfare losses in light of their high ratios of imports to GDP.
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Philippines, and Thailand since it offers the least welfare loss. This is consistent with the
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20 | ADB Economics Working Paper Series No. 299
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At a broader level, our analysis can provide some guidance about monetary policy
regimes for small open economies. For such economies, which depend heavily on
exports and trade for growth, the capacity of monetary policy to cushion the impact of
adverse external output shocks is one of the most important criteria for the appropriate
policy regime. The pronounced impact of the recession in the advanced economies on
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delivers the least welfare loss for most East Asian small open economies except for those
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&3,LQDWLRQWDUJHWLQJIRUVPDOORSHQHFRQRPLHVPD\EHWKDWLWSURWHFWVWKHPEHWWHUIURP
external output shocks.
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 21
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A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock | 23
A Welfare Evaluation of East Asian Monetary Policy Regimes under Foreign Output Shock
Joseph D. Alba, Wai-Mun Chia, and Donghyun Park assess the welfare impact of external shocks
under diferent monetary policy regimes in East and Southeast Asia. To do so, they numerically
solve and calculate the welfare loss function of a dynamic stochastic general equilibrium (DSGE)
model with complete exchange rate pass through. Their DSGE model simulation results suggest
that consumer price index infation targeting delivers the least welfare losses for most small open
economies in East and Southeast Asia.
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