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Financial Frictions and Unconventional Monetary Policy in Emerging Economies

Roberto Chang and Andrés Velasco

No 21955, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We analyze conventional and unconventional monetary policies in a dynamic small open-economy model with financial frictions. In the model, financial intermediaries or banks borrow from the world market and lend to domestic households. Banks can borrow abroad up to a multiple of their equity; in turn, there is a limit to how much bank equity households can hold. An economy-wide credit constraint and an endogenous interest rate spread emerge from this combination of external and domestic frictions. The resulting financial imperfections amplify the domestic effects of exogenous shocks and make those effects more persistent. In response to external balance shocks, fixed exchange rates are contractionary and flexible exchange rates expansionary (although less so in the presence of currency mismatches); the opposite is true in response to increases in the world interest rate. Unconventional policies, including central bank direct credit, discount lending, and equity injections to banks, have real effects only if financial constraints bind. Because of bank leverage, central bank discount lending and equity injections are more effective than direct credit. Sterilized foreign exchange intervention is equivalent to lending directly to domestic agents. Unconventional policies are feasible only to the extent that the central bank holds a sufficient amount of international reserves.

JEL-codes: E52 E58 F41 (search for similar items in EconPapers)
Date: 2016-02
New Economics Papers: this item is included in nep-cba, nep-dge, nep-ifn, nep-mac, nep-mon and nep-opm
Note: IFM
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Published as Roberto Chang & Andrés Velasco, 2017. "Financial Frictions and Unconventional Monetary Policy in Emerging Economies," IMF Economic Review, vol 65(1), pages 154-191.

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