Revisiting the Gali–Monacelli Small Open Economy Model: A Calibrated DSGE Comparison of Pakistan and Canada

Abstract

This study explores the structural factors that differentiate the macroeconomic responses of Pakistan and a developed economy to domestic and global shocks within a Dynamic Stochastic General Equilibrium (DSGE) framework. Using the model put forward in Gali & Monacelli (2005), we calibrated key parameters to reflect Pakistan’s economy, allowing for a comparative analysis of impulse response functions (IRFs) generated for output, inflation, interest rate, and exchange rate under (a) the labour productivity and (b) the world demand shock. In comparison with those for Canada – an advanced economy. The estimation of model parameters for Pakistan reveals relatively lower degree of openness, higher sensitivity of inflation to the output gap, lower price stickiness, lower coefficient of relative risk aversion (CRRA), lower disutility of labour supply and lower persistence of productivity shocks. These factors lead to a larger initial, however, less persistent monetary policy response than in Canada, higher inflation volatility, and shorter-lived benefits from productivity gains. Just to contextualise, if only the persistence of the positive productivity shock for Pakistan is equated to that of Canada, the output response more than doubles, highlighting the need for undertaking work on the most probable missing component i.e., the structural reforms for productivity enhancement.