When studying issues like features of optimal monetary policy for a given economy, a choice must be made between using an open economy or a closed-economy model.
How to make this choice? On one hand, you can say that, well, every economy participates in international trade, so no economy is a closed economy. But the degree of openness matters for this choice, right?
My economy is small and commodity-dependent (Ghana). In my recent research, I found that commodity price shocks do not affect the business cycle at all using an atheoretical SVAR model, plus other pieces of evidence. I found that this is plausible because (1) the government sells the economy’s cocoa output in forward contracts to protect the economy from commodity price shocks. (2) Gold companies in Ghana sell in the spot market, however, a lot of the mining firms are foreign-owned, so a lot of the foreign exchange does not come back. And hence there is no big effect of a gold price shock on the exchange rate, inflation rate, interest rate, output, employment, etc.
Moreover, there is less synchronicity between Ghana’s business and that of other economies, regions, and the global economy (even that of its neighbors and trading partners). I found some arguments in the literature that this may be because the agricultural sector is large in African economies, insulating these economies from shocks that emanate from outside the economy. Given the above, should I use a closed economy model or an open economy model when studying features of optimal monetary policy for Ghana? Maybe, there is no definite answer, but, it looks like a closed economy to me in terms of trade (more than an open economy), in the sense that foreign shocks do not affect the business cycle via the trade sector.
Also, Ghana is not an economy where a lot of the citizens trade in financial assets to smooth consumption. The government, however, does borrow from abroad. So when the Ukraine war started, for example, prices went up in major advanced economies, interest rates then went up, and foreign investors abandoned the foreign bonds issued by our government. It resulted in a strong depreciation of the exchange rate, resulting in an inflation crisis.
Can I use a closed-economy model to model Ghana’s business cycle, and capture external shocks (that cause inflation) as inflation shocks or supply shocks hitting the Phillips curve? Or what model assumption would be appropriate in this scenario? I am studying features of optimal policy for Ghana. Thanks for help!!