Optimal monetary policy in a currency union with interest rate spreads

Saroj Bhattarai, Jae Won Lee and Woong Yong Park

Journal of International Economics, 2015, vol. 96, issue 2, 375-397

Abstract: We introduce “financial imperfections” – asymmetric net wealth positions, incomplete risk-sharing, and interest rate spreads across member countries – in a prototypical two-country currency union model and study implications for monetary policy transmission mechanism and optimal policy. In addition to, and independent from, the standard transmission mechanism associated with nominal rigidities, financial imperfections introduce a wealth redistribution role for monetary policy. Moreover, the two mechanisms reinforce each other and amplify the effects of monetary policy. On the normative side, financial imperfections, via interactions with nominal rigidities, generate two novel policy trade-offs. First, the central bank needs to pay attention to distributional efficiency in addition to macroeconomic (and price level) stability, which implies that a strict inflation targeting policy of setting union-wide inflation to zero is never optimal. Second, the interactions lead to a trade-off in stabilizing relative consumption versus the relative price gap (the deviation of relative prices from their efficient level) across countries, which implies that the central bank allows for less flexibility in relative prices. Finally, we consider how the central bank should respond to a financial shock that causes an increase in the interest rate spread. Under optimal policy, the central bank strongly decreases the deposit rate, which reduces aggregate and distributional inefficiencies by mitigating the drop in output and inflation and the rise in relative consumption and prices. Such a policy response can be well approximated by a spread-adjusted Taylor rule as it helps the real interest rate track the efficient rate of interest.

Keywords: Currency union; Optimal monetary policy; Redistributive monetary policy; Financial frictions; Interest rate spreads; Spread-adjusted Taylor rule (search for similar items in EconPapers)
JEL-codes: E31 E52 E61 F33 F41 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (16)

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Working Paper: Optimal monetary policy in a currency union with interest rate spreads (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:96:y:2015:i:2:p:375-397

DOI: 10.1016/j.jinteco.2015.02.002

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