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We build a small open economy New Keynesian dynamic stochastic general equilibrium model for South Africa similar to Steinbach "et al". We abandon their assumption of complete risk sharing with the foreign economy, and introduce country risk shocks to allow deviations from uncovered interest rate parity. These changes allow us to include the exchange rate as an observable variable in the estimation of the model. Using forecast error variance decompositions and historical decompositions, we show that country risk shocks have sizable effects on the South African business cycle. We also explore the optimal monetary policy implications of our model within the context of Taylor rules. Copyright (c) 2010 The Authors. Journal compilation (c) 2010 Economic Society of South Africa.

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This is a working paper and the author would welcome any comments on the present text. Citations should refer to an unpublished manuscript, mentioning the author and the date of issuance by the International Monetary Fund The views expressed are those of the author and do not necessarily represent those of the Fund.