Advantages of Fixed Exchange Rate Regime from a General Equilibrium Perspective

Working Paper 4/2009

Abstract
In this paper we estimate a small open economy DSGE model for Latvia following Lubik and Schorfheide (2007) using Bayesian methods. The estimates of the structural parameters fall within plausible ranges. Simulation results suggest that under inflation targeting inflation turns out to be more volatile than under the peg in the case of Latvia. Additional concern for output stabilisation accounts for lower inflation variability while it is still higher than under existing exchange rate regime with ±1% fluctuation bands. The model results therefore support the existing exchange rate policy.

Keywords: DSGE, small open economy, exchange rate policy, Bayesian estimation

JEL codes: C11, C3, C51, D58, E58, F41