DYNAMICS OF OPTIMUM MONETARY POLICY IN A SMALL OPEN-ECONOMY: A NEW-KEYNESIAN DSGE MODEL FOR TURKISH ECONOMY

Abstract

The purpose of this paper is to investigate the sources of business cycle fluctuations in a small open economy (SOE) using dynamic stochastic general equilibrium (DSGE) models and to assess the path of optimal policy decisions taken by the Central Bank of the Republic of Turkey (CBRT). To that purpose, the SOE-DSGE model is estimated using the Bayesian technique with Turkish data spanning the quarters 2003Q2–2020Q1. Based on the estimated model, the study finds that the explanatory power of the SOE-DSGE model for household, firm and central bank behavior decreases when consumer habit formation, price indexation and exchange rate sensitivity are included. Furthermore, technology, preferences, and risk premium shocks all have a significant impact on the Turkish economy. The CBRT, on the other hand, was principally concerned with price stabilization, interest rate smoothing, output and output growth stabilization, and nominal exchange rate stabilization, respectively. More importantly, the optimal monetary policy function implies that output growth should be better stabilized if exchange rate sensitivity target is ignored.