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Asset Prices and Financial Frictions in Monetary Transmission: The Case of Latvia

Kristine Vitola and Ludmila Fadejeva
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Kristine Vitola: Bank of Latvia

No 2010/03, Working Papers from Latvijas Banka

Abstract: The purpose of this paper is to quantify the role of financial frictions in Latvia's monetary transmission. Our model extends M. Iacoviello (9) framework along three dimensions. First, we introduce open-economy features by allowing imports of foreign consumer goods and borrowing from abroad. Second, we relax the assumption of fixed housing stock, allowing for investment. Finally, we assume a risk premium on foreign borrowing, which depends on net foreign asset position. We estimate the model by Bayesian approach and compare impulse responses to shocks under various scenarios. In addition to the baseline scenario, we explore the importance of tighter borrowing constraints and higher foreign risk premium elasticity in the model dynamics. Our findings show that tighter credit constraints weaken the transmission of shocks to housing demand and consumption. In the case of foreign interest rate and risk premium shocks, higher risk premium elasticity lessens the effect of monetary transmission on the domestic economy through higher cost of external funds.

Keywords: financial frictions; monetary transmission; asset prices; DSGE model; Bayesian approach (search for similar items in EconPapers)
JEL-codes: C11 E32 E44 E52 R21 (search for similar items in EconPapers)
Date: 2010-12-23
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ltv:wpaper:201003

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