Financial Distress and Unconventional Monetary Policy in Financially Open Economies

Eliezer Borenstein () and David Elkayam ()

No 2016.09, Bank of Israel Working Papers from Bank of Israel

Abstract: How does financial openness of an economy facing domestic financial frictions change the propagation of shocks? How does it affect the potential effectiveness or desirability of unconventional monetary policy intended to mitigate the effects of adverse shocks? We analyze these questions by applying the setup of Gertler and Karadi (2011) to an open economy. Our results show that the answers to these questions depend on the openness structure of the economy: it matters which sector (households, firms, or both) has access to the global financial markets. In particular, we find that with regard to productivity shocks, financial openness generally mitigates the effects of the shocks relative to the closed economy. In contrast, with regard to financial shocks we find that financial openness can strongly exacerbate their effect: when the economy is open only to households' savings (so that they can deposit abroad as well), the effect of financial shocks is amplified relative to the closed economy case. When the economy is open to firms borrowing (so that they can borrow from abroad as well), the effect on the economy becomes ambiguous. As for the effectiveness of an asset purchase policy, we find that in some openness structures its effect is strengthened relative to the closed economy, while in others it could even be detrimental to the economy.

Keywords: unconventional monetary policy; financial frictions; financial intermediaries; financial distress; real business cycle; small open economy (search for similar items in EconPapers)
JEL-codes: E32 E44 E52 F41 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2016-06
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