Financial frictions and optimal monetary policy in an open economy

Giovanni Lombardo and Marcin Kolasa

No 1338, Working Paper Series from European Central Bank

Abstract: A growing number of papers have studied positive and normative implications of financial frictions in DSGE models. We contribute to this literature by studying the welfare-based monetary policy in a two-country model characterized by financial frictions, alongside a number of key features, like capital accumulation, non-traded goods and foreign-currency debt denomination. We compare the cooperative Ramsey monetary policy with standard policy benchmarks (e.g. PPI stability) as well as with the optimal Ramsey policy in a currency area. We show that the two-country perspective offers new insights on the trade-offs faced by the monetary authority. Our main results are the following. First, strict PPI targeting (nearly optimal in our model if credit frictions are absent) becomes excessively procyclical in response to positive productivity shocks in the presence of financial frictions. The related welfare losses are non-negligible, especially if financial imperfections interact with nontradable production. Second, (asymmetric) foreign currency debt denomination affects the optimal monetary policy and has important implications for exchange rate regimes. In particular, the larger the variance of domestic productivity shocks relative to foreign, the closer the PPI-stability policy is to the optimal policy and the farther is the currency union case. Third, we find that central banks should allow for deviations from price stability to offset the effects of balance sheet shocks. Finally, while financial frictions substantially decrease attractiveness of all price targeting regimes, they do not have a significant effect on the performance of a monetary union agreement. JEL Classification: E52, E61, E44, F36, F41

Keywords: financial frictions; open economy; optimal monetary policy (search for similar items in EconPapers)
Date: 2011-05
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
Note: 656519
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

Downloads: (external link)
https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp1338.pdf (application/pdf)

Related works:
Journal Article: Financial Frictions and Optimal Monetary Policy in an Open Economy (2014)
Working Paper: Financial frictions and optimal monetary policy in an open economy (2011)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20111338

Access Statistics for this paper

More papers in Working Paper Series from European Central Bank 60640 Frankfurt am Main, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Official Publications ().