Testing small open economy DSGE model with imperfect pass-through using indirect inference

The response of consumer price to exchange rate fluctuations has been a major challenge for policy analysis. This paper develops a model of imperfect exchange rate pass-through within an open economy DSGE framework using quarterly UK data. The majority of papers use partial equilibrium models such as simple regressions rather than the general equilibrium model presented in this thesis. The former models have their own drawbacks, which significantly affect the inferences on a passthrough degree. Although some prior literature on pass-through analysis estimated the degree of pass-through in general equilibrium models, the overall performance of the models has been assessed by techniques such as fitting moment conditions. This work, on the other hand, uses Indirect Inference which has proved to be a more powerful test than standard testing tools such as moment comparisons or even the Likelihood Ratio test. Thus, in this thesis, I am testing the DSGE model where price rigidity is taken as a source of the sluggish response of prices to exchange rate movements. Consistent with previous studies, the thesis also concludes that the impact on consumer prices depends on the nature of macroeconomic shocks. The key to understanding this phenomenon lies in how the economy reacts to different shocks in the economy: whether the shock comes from foreign suppliers, domestic demand, or changes in monetary policy. The paper goes further and explores the reason behind different responses of CPI and exchange rate to different structural shocks. Therefore, the co-movement of exchange rate and CPI has been disentangled into separate dynamics. And the analysis shows that different behaviour under various shocks highly depends on estimated structural parameters