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Financial Frictions and Optimal Monetary Policy in an Open Economy

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  • Marcin Kolasa

    (Narodowy Bank Polski and Warsaw School of Economics)

  • Giovanni Lombardo

    (European Central Bank)

Abstract

We study welfare-based monetary policy in a two-country DSGE model characterized by financial frictions. We compare the cooperative Ramsey monetary policy with standard policy benchmarks as well as with the optimal Ramsey policy in a currency area. Our main results are the following. First, strict PPI targeting becomes excessively procyclical in response to productivity shocks in the presence of financial frictions. Second, foreign-currency debt denomination affects the optimal monetary policy and has important implications for exchange rate regimes. Third, we find that central banks should allow for deviations from price stability to offset the effects of balance sheet shocks. Fourth, 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. We show that the twocountry perspective offers new insights on the trade-offs faced by the monetary authority. For example, exchange rate adjustments tend to introduce a wedge between the external cost of finance across countries and, hence, they make the cooperative goal of return equalization a more difficult task.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 10 (2014)
Issue (Month): 1 (March)
Pages: 43-94

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Handle: RePEc:ijc:ijcjou:y:2014:q:1:a:2

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Cited by:
  1. PIROVANO, Mara, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Papers 2013014, University of Antwerp, Faculty of Applied Economics.
  2. Michał Brzoza‐Brzezina & Marcin Kolasa, 2013. "Bayesian Evaluation of DSGE Models with Financial Frictions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(8), pages 1451-1476, December.
  3. Scott Davis & Kevin X.D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization and Monetary Policy Institute Working Paper 85, Federal Reserve Bank of Dallas.
  4. PIROVANO, Mara, 2013. "International financial integration, credit frictions and exchange rate regimes," Working Papers 2013015, University of Antwerp, Faculty of Applied Economics.
  5. Michał Brzoza-Brzezina & Marcin Kolasa & Krzysztof Makarski, 2011. "The anatomy of standard DSGE models with financial frictions," National Bank of Poland Working Papers 80, National Bank of Poland, Economic Institute.
  6. Viktors Ajevskis & Kristine Vitola, 2011. "Housing and Banking in a Small Open Economy DSGE Model," Working Papers 2011/03, Latvijas Banka.
  7. Dedola, Luca & Karadi, Peter & Lombardo, Giovanni, 2013. "Global implications of national unconventional policies," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 66-85.

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