A multi-country DSGE model with incomplete Exchange Rate Passthrough:application for the Euro area.

This paper develops an estimated multi-country open economy dynamic stochastic gen- eral equilibrium (DSGE) model with incomplete Exchange Rate Pass-Through (ERPT) for the Euro-area. It is designed to model global international linkages and to assess inter- national transmission of shocks under an endogenous framework and incomplete ERPT assumption. On the one hand, we relax the small open economy framework (SOEF) but derive a canonical representation of the equilibrium conditions to maintain analytical tractability of the complex international transmission mechanism underlying the model. Namely, the model considers economies of di¤erent size that are open and endogenously related. On the other hand, in order to take into account international linkages, possible cointegration relationships within domestic variables and between domestic and foreign variables, and the role of common unobserved and observed global factors such as the oil price, we use the Global VAR model to estimate the steady state of observed endoge- nous variables of the multi-country DSGE model. Namely, steady states are computed as long-horizon forecasts from a reduced-form cointegrating GVAR model. ERPT analysis conducted from the estimated multi-country DSGE model for the Euro-area in relation with its …ve main trade partners which are the United Kingdom, the United States, China, Japan and Switzerland yields the following results. First, exchange rate volatility contributes to a large part of import price in‡ation variation of the Euro-area in contrast to foreign mark-up shocks. Second, deviation from in‡ation objective of the foreign trade partners contributes to another source of the Euro-area import price variability. Third, nominal rigidity induces a persistent but a lower impact of the exchange rate changes on import in‡ation.