Should Hong Kong switch to Taylor rule?—Evidence from DSGE model

This paper studies the economy of Hong Kong through the lens of a small open economy DSGE model with a currency board exchange rate commitment. It assumes flexible prices and a banking system that provides credit to entrepreneurial household firms; the money supply is fully backed by reserves under the currency board. We estimate and evaluate the model by Indirect Inference over the sample period of 1994Q1-2018Q3; we find that it matches the data behaviour as represented by a VAR. We examined the economy’s volatility using bootstrapping of the model innovations, under both the estimated currency board model and a standard alternative regime with floating exchange rate and a Taylor rule; we found that Hong Kong welfare is higher in the currency board, which substantially reduces output volatility