Due date: Friday 2 June, 11:59pm
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1 The model (equations and variables)
1.1 The model in brief
The model you will analyze is a simpli ed version of the New-Keynesian small open
economy (SOE) model in Justiniano and Preston (2010), which in turn is based on the
model in Monacelli (2005) and Gali and Monacelli (2005). Compared to Justiniano and
Prestonís model, our simpli ed model assumes that the law of one price (LoP) holds for
all imported retail goods and there is no price indexation for these imported goods. The
model is also extended to include labor-supply shocks, which could be used as a proxy
for the supply-side disruption of the COVID-19 pandemic. Aggregate áuctuations in our
model model are driven by 7 exogenous shocks: risk premium, monetary policy (money
supply), preference (consumer spending), labor supply, foreign ináation, foreign output,
and foreign interest rate.
The model can be derived from the ground up with micro-foundations, based on op
timizing households, domestic rms and importers, etc., resulting in a set of non-linear
equations. We will instead work directly with the log-linearized equilibrium equa
tions, listed below.
1.2 The log-linearized equations
Consumption Euler-equation (the IS equation):
b
ct =
h
1 +
h b
ct
