Supply, Demand and Monetary Policy Shocks in a Multi-Country New Keynesian Model

This paper estimates and solves a multi-country version of the standard New Keynesian, MCNK, model. Modelling a large number of countries requires a range of methodological innovations. Each country has a Phillips curve determining inflation, an IS curve determining output, a Taylor Rule determining interest rates, and a real effective exchange rate equation. All variables are measured as deviations from their steady states, estimated as long-horizon forecasts from a reduced-form cointegrating global VAR. The rational expectations model is estimated for 33 countries, 1980Q1-2006Q4, by inequality constrained IV, using lagged and contemporaneous foreign variables as instruments, subject to NK theoretical restrictions. The MCNK model is then solved to provide estimates of identified supply, demand and monetary policy shocks. Within a country supply, demand and monetary policy shocks are orthogonal, though shocks of the same type (e.g. supply shocks in different countries) can be correlated. We present impulse response functions and variance decompositions allowing for both direct channels of international transmission through regression coefficients and indirect channels through error spillover effects. Bootstrapped error bands are also provided for the cross country responses of a shock to the US monetary policy.