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Optimal Monetary Policy in a Currency Union: Implications of Country-specific Financial Frictions

Jochen Michaelis and Jakob Palek ()
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Jakob Palek: Department of Economics University of Kassel Nora-Platiel-Str. 4 D-34127 Kassel Germany

Credit and Capital Markets, 2016, vol. 49, issue 1, 1-36

Abstract: There is growing empirical evidence that the strength of financial frictions differs across countries. Using the cost channel approach, we show how the introduction of (country-specific) financial frictions alters the optimal monetary responses to union-wide and national non-financial shocks in a New Keynesian model of a two-country monetary union. By causing a cost-push effect on inflation, financial frictions make monetary policy less effective in combating inflation. We show that the optimal response to the decline in effectiveness is a stronger use of the interest-rate instrument. On the other hand, the larger the differential of financial frictions across member states, the less aggressive will the optimal monetary policy be. For almost all parameter constellations, our welfare analysis suggests a clear-cut ranking of policy regimes: commitment outperforms the Taylor rule, the Taylor rule outperforms strict inflation targeting, and strict inflation targeting outperforms discretion.

Keywords: financial frictions; cost channel; optimal monetary policy; monetary union (search for similar items in EconPapers)
JEL-codes: E31 E52 F41 (search for similar items in EconPapers)
Date: 2016
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Handle: RePEc:kuk:journl:v:49:y:2016:i:1:p:1-36