Evaluating an estimated new Keynesian small open economy model

This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano et al. [2005. Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113(1), 1-45] and Smets and Wouters [2003. An estimated stochastic dynamic general equilibrium model of the Euro area. Journal of the European Economic Association 1(5), 1123-1175] using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank's instrument rule. A key equation in the model - the uncovered interest rate parity (UIP) condition - is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.