Modelling Money Shocks In A Small Open Economy: The Case of Taiwan

This paper explores the relevance of the Divisia monetary aggregate in Taiwan over the period January, 1985 through to June, 2016. We apply a block recursive structural VAR approach that is adapted to a small open economy by adding the New Taiwan Dollar / US Dollar exchange rate to the block of economic activity indicators. We test the hypothesis that measures of money constructed using the Divisia index number formulation are superior indicators of monetary conditions when compared to the central bank’s main policy rate, the Taiwanese discount rate. We find that using properly measured monetary data solves short-run price, output and exchange rate puzzles and leads to sensible long-run impulse responses to monetary shocks. Future work on the optimisation of the construction of the Divisia index number formulation is recommended.