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Financial frictions and optimal stabilization policy in a monetary union

Jakob Palek and Benjamin Schwanebeck ()

Economic Modelling, 2017, vol. 61, issue C, 462-477

Abstract: Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.

Keywords: Cost channel; Financial frictions; Optimal policy; Monetary policy; Fiscal policy; Monetary union (search for similar items in EconPapers)
JEL-codes: E E E E (search for similar items in EconPapers)
Date: 2017
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