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Essays on trend inflation in the open-economy

Yılmaz, Yusuf Ömü
The existing new Keynesian open economy literature tends to make a simplifying assumption that there is no trend inflation. The dissertation is composed of two essays which incorporate positive trend inflation into Open Economy New-Keynesian Models. In the first essay, a standard small open economy model is reformulated to account for positive trend inflation. Then, the model is used to understand the effects of macroeconomic shocks in a small open economy when trend inflation is positive. The main finding is that allowing for trend inflation significantly affects the implications of the dynamics of real exchange rate. Specifically, higher trend inflation induces more persistent real exchange rate responsiveness to shocks. Furthermore, adding trend inflation to the standard model improves the model in the direction of resolving the Purchasing Power Parity and Delayed-overshooting Puzzles. In the second essay, two-open and identical economy model is extended to account for positive trend inflation and heterogeneity-in price stickiness. Then, this model is used to analyse the effect of increased trade openness on the determinacy region at different rates of trend inflation. It is found that positive trend inflation shrinks the determinacy region more as the degree of openness increases. The shrinkage is higher in the version of the model with heterogeneity in price stickiness. Moreover, it is discussed how monetary policy transmission mechanism differs to that in closed-economy model and how those differences affect the dynamics of macroeconomics variables.