Closing the model: marginal models for feedback variables
We have established a wage-price model conditional upon the exchange rate vt (which works through pit), GDP mainland output yt, the rate of unemployment ut, and average labour productivity at. In this section, we enlarge the model to include relationships for these four variables and functions for real credit crt, and two interest rates: for government bonds RBOt and for bank loans RLt. This serves three purposes: first, all of these variables are affected by the monetary policy instrument (represented in the model by the money market interest rate) and are therefore channels for monetary instruments to influence inflation; second, none of these variables are likely to be strongly exogenous. For example, import prices depend by definition on the nominal exchange rate. Below we report a model that links the exchange rate to the lagged real exchange rate, which in turn depends on the domestic price level; third, we make use of the marginal models to test the exogeneity assumptions that underlie the estimation strategy of the wage-price model as well as conditions for valid use of the full model for policy simulations.