Appendix I. Algeria: Microeconomic Foundations of the Model
Berg, Andrew, Philip Karam, and Douglas Laxton, 2006, “Practical Model-Based Monetary Policy Analysis—A How to Guide,” IMF Working Paper 06/81 (Washington: International Monetary Fund).
Calvo, Guillermo A., 1983,” Staggered Prices in a Utility-maximizing Framework, Journal of Monetary Economics, Vol. 12(3), 383–398.
Clarida, Richard, Jordi Gali J, and Mark Gertler, 1999, “The Science of Monetary Policy: A New Keynesian Perspective,” Journal of Economic Literature, Vol. 37(4), 1661–1707.
Gali, Jordi, and Tommasso Monacelli, 2005, “Monetary Policy and Exchange Rate Volatility in a Small Open Economy Model,” Review of Economic Studies, Vol. 72, 707–34.
International Monetary Fund, 2011, “Target What You Can Hit: Commodity Price Swings and Monetary Policy,” in World Economic Outlook (Washington: International Monetary Fund).
Kumhof and Laxton, 2008, “Chile’s Structural Fiscal Surplus Rule: A Model-Based Evaluation,” IMF Working Paper 09/88 (Washington: International Monetary Fund).
Ostry, Jonathan D., Atish R. Gosh, and Marcos Chamon, 2012, “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies,” IMF Staff Discussion Note 12/01 (Washington: International Monetary Fund).
Prepared by Moez Souissi. The model was built in collaboration with Jan Vlcek (Czech National Bank).
See 2014 Selected Issues Paper: “Enhancing the Effectiveness of Monetary Policy in Algeria.”
A detailed description of micro-foundations of the model and its derivation is provided in Appendix I.
Key equations of the model are based on explicit assumptions about the behavior of the main economic actors in the economy (households, firms, and the government). These agents interact in market that clear every period, which leads to the general equilibrium feature of the model.
To keep the model tractable, we do not model investment. It would require introducing an additional state variable for capital, and its accumulation. Hence, we simply aggregate investment together with private consumption.
Equation (2) describes the dynamics of private absorption and not its level, which is determined by the country’s revenues, particularly from the hydrocarbon sector.
σ is a constant intertemporal elasticity of substitution (IES) of consumption.
We calibrate β1 to 0.8 which is at the edge of the range of parameter values used in the literature (i.e., between 0.5 and 0.8). This value indicates the high degree of private consumption persistence, consistent with the data for Algeria.
The share of government transfers accruing to each household type is determined by its share of total labor hours, and is kept constant.
In the absence of any explicit fiscal rule for Algeria, fiscal policy becomes neutral, in that it fully accommodates the oil price shock by adjusting expenditures accordingly.
As such, transfers in the model can be interpreted as subsidies net of taxes.
Equation (3) implies that that any shock to oil production,
For domestic final good production, we assume a Leontief production function that combines both imported and domestic intermediate goods and services. As a result, the shares of domestic and imported goods in total production are invariant, and therefore the demand for these two types of goods does not depend on their relative prices. For the production of domestic intermediate goods, we assume a Cobb-Douglas production function with labor being the only production factor. The final good production is the sum of private and public consumption.
Equation (9) can be written as follows:
This specification can be derived from micro-foundations. The real marginal costs represent the natural logarithm of marginal cost in deviation from the price index that maximizes the profit of the representative firm in that sector. We assume that the production of final consumption goods requires both domestic and imported inputs.
Setting e2 equal to 0, we capture the case of fully pegged exchange rate to a particular target level
We undertook a number of sensitivity analyses assuming different values of α1 and θ1. The results presented below remain qualitatively the same.
To simulate a fully flexible exchange rate regime, we set δ1 equal to 0.
Implicitly, the central bank pays attention to real economic developments. Such a course may be desirable for restoring employment as wages are relatively inflexible. A higher inflation would help achieve the necessary downward adjustment in real wages faster.
To simulate a peg regime, we set δ1 and e2 equal to 1 and 0.25, respectively.
Note that interest rates partly increase due to higher country risk premium reflecting the increase in public debt (Equation 21).
This feature can be easily changed assuming differentiated types of labor supplied by households. In such a case households exhibits a monopolistic power setting their wages.