Unconventional monetary policy in a small open economy under inflation targeting regime

In this paper, we focus on consequences of unconventional monetary policy, namely, of interventions on foreign exchange (FX) market. In recent development of many economies, interest rate hit the zero lower bound, making traditional instrument of monetary policy unemployable. Depreciation of country's currency and subsequent interventions on FX market therefore provide for an option for inflation targeting in small open economies. We use a New-Keynesian dynamic stochastic model of general equilibrium. The possibility of central bank's interventions is modeled by adding a segment of FX dealers as a modified uncovered interest parity condition, according to [2]. The model is then estimated on data of Czech economy. We then introduce non-linearities to otherwise linear model, providing a way to model constraints on variables. Constraint on interest rate is chosen to model the position of the economy at zero lower bound, whereas constraint on exchange rate is used to model commitment of central bank to keep exchange rate above certain value. Model is solved using toolbox of [3], which introduces a way of dealing with non-linear models, by assuming perfect foresight of agents. Finally, the results are assessed and correctness of unconventional monetary policy is evaluated.