Optimal monetary policy in the new Keynesian model: an estimated dynamic stochastic general equilibrium model

Dynamic Stochastic General Equilibrium (DSGE) models have been widely used for monetary policy analysis in recent years. On the other hand central banks develop their own DSGE models. Advantage of these models is that they fit data well because they are based on microfoundations. In this study, a small open economy DSGE model are estimated for Turkey. Firstly detailed derivation of New Keynesian model are presented. The model features nominal and real rigidities, imperfect competition and habit formation in the consumers utility function. Later optimal monetary policy is explained in detail in the New Keynesian macroeconomic framework. The model is estimated using by Bayesian methods for the period 2002:Q1 - 2012:Q4. To apply this methodology priors and the likelihood function are combined to obtain the posterior distribution of structural parameters. The likelihood function of the parameters is evaluated using Kalman filter of log-linear approximation of the model. Metropolis-Hastings algorithm is used to approximate the posterior distribution. The parameter estimates shows that monetary authority reacts to inflation robustly while it reacts to the output gap weakly.