Small-open-economy NK Model

Evidence and data

Read inflation, output, exchange rates, import prices, external demand, and risk premia together.

Calibration or measurement

Openness, exchange-rate pass-through, foreign-demand persistence, and risk-premium shocks dominate results.

Boundaries

• Large-country spillbacks are outside the small-economy assumption.
• Currency mismatch needs another balance-sheet block.
• Capital controls are not native to the baseline.

Use guidance

When sufficient

Monetary policy analysis, exchange-rate pass-through, and external-demand spillovers in a small open economy with a floating rate and open capital account. The Gali-Monacelli 2005 (RES) framework gives clean forward-looking predictions for the optimal policy trade-off between domestic inflation and the output gap when imported goods enter CPI and the law of one price holds at the border.

When sketch only

Use as the open-economy extension of the standard three-equation NK model, not as a model of capital-flow surges, dollarization, or sudden stops. The small-economy assumption rules out spillbacks from domestic policy to the rest of the world. Sterilized intervention, currency mismatch on bank balance sheets, and sovereign risk premia each require a separate block.

When to switch

Switch to a model with imperfect capital mobility or portfolio balance (Schmitt-Grohe-Uribe 2003 JIE debt-elastic premium) when the interest-parity condition fails persistently. Switch to a sudden-stop model (Mendoza 2010 AER) when binding collateral constraints and capital reversals define the episode.

Falsification signal

Exchange-rate pass-through that is systematically near zero during non-stress periods but spikes or reverses during risk-off episodes violates the model's assumption of stable import-price elasticity. If the domestic inflation response to a 10 percent depreciation swings from near zero to 2 or 3 percent depending on the financial-stress regime, the constant-pass-through parameter is misspecified.