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Monetary Rules in Emerging Economies with Financial Market Imperfections

In: International Dimensions of Monetary Policy

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  • Nicoletta Batini
  • Paul Levine
  • Joseph Pearlman

Abstract

We build a two-bloc emerging market - rest of the world model. The emerging market bloc incorporates partial transactions and liability dollarization, as well as financial frictions including a ‘financial accelerator’, where capital financing is partly or totally in foreign currency as in Gertler et al. (2003) and Gilchrist (2003)). Simulations of the model under various ‘operational’ monetary policy rules derived assuming that the central bank maximizes households’ utility point to important results. First, we reaffirm the finding in the literature that financial frictions, especially when coupled with liability dollarization, severely increase the costs of a fixed exchange rate regime. By contrast, transactions dollarization has only a small impact on the choice of the monetary regime. Second, central banks in emerging economies with these frictions should not explicitly target the exchange rate; nor should they implicitly do so by choosing a CPI rather than domestic price inflation target. Third, with dollarization and frictions, the zero lower bound constraint on the nominal interest rate makes simple Taylor-type rules perform much worse in terms of stabilization performance than fully optimal monetary policy.

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This chapter was published in:

  • Jordi Galí­ & Mark J. Gertler, 2010. "International Dimensions of Monetary Policy," NBER Books, National Bureau of Economic Research, Inc, number gert07-1.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 0519.

    Handle: RePEc:nbr:nberch:0519

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    References

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    1. Batini, Nicoletta & Harrison, Richard & Millard, Stephen P., 2003. "Monetary policy rules for an open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 27(11), pages 2059-2094.
    2. Pierpaolo Benigno, 2009. "Price Stability with Imperfect Financial Integration," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 41(s1), pages 121-149, 02.
    3. Coenen, Günter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Working Paper Series 0218, European Central Bank.
    4. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
    5. Mark Gertler & Simon Gilchrist & Fabio Natalucci, 2001. "External constraints on monetary policy and the financial accelerator," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
    6. Eduardo Levy-Yeyati, 2004. "FINANCIAL DOLLARIZATION: Evaluating the consequences," Econometric Society 2004 Latin American Meetings 184, Econometric Society.
    7. Levine, Paul & McAdam, Peter & Pearlman, Joseph, 2008. "Quantifying and sustaining welfare gains from monetary commitment," Journal of Monetary Economics, Elsevier, vol. 55(7), pages 1253-1276, October.
    8. Eggertsson, Gauti B., 2006. "The Deflation Bias and Committing to Being Irresponsible," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 38(2), pages 283-321, March.
    9. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 199-216, March.
    10. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
    11. Benigno, Gianluca & Benigno, Pierpaolo, 2008. "Exchange rate determination under interest rate rules," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 971-993, October.
    12. Noah Williams & Andrew Levin & Alexei Onatski, 2005. "Monetary Policy under Uncertainty in Micro-Founded Macroeconometric Models," Computing in Economics and Finance 2005, Society for Computational Economics 478, Society for Computational Economics.
    13. N. Batini & P. Levine & J. Pearlman, 2003. "Indeterminacy with inflation-forecast-cased rules in a two-bloc model," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
    14. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 728-752, April.
    15. Guillermo A. Calvo & Frederic S. Mishkin, 2003. "The Mirage of Exchange Rate Regimes for Emerging Market Countries," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 99-118, Fall.
    16. Aoki, Kosuke & Kimura, Takeshi, 2007. "Uncertainty about perceived inflation target and monetary policy," Discussion Paper Series 1: Economic Studies 2007,18, Deutsche Bundesbank, Research Centre.
    17. Simon Gilchrist & Jean-Olivier Hairault & Hubert Kempf, 2002. "Monetary policy and the financial accelerator in a monetary union," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 750, Board of Governors of the Federal Reserve System (U.S.).
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    Citations

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    Cited by:
    1. Levine, Paul & Pearlman, Joseph G. & Pierse, Richard, 2007. "Linear-quadratic approximation, external habit and targeting rules," Working Paper Series 0759, European Central Bank.
    2. Nicoletta Batini & Eugen Tereanu, 2009. "What Should Inflation Targeting Countries Do When Oil Prices Rise and Drop Fast?," IMF Working Papers 09/101, International Monetary Fund.
    3. Garcia, Carlos J. & Restrepo, Jorge E. & Roger, Scott, 2011. "How much should inflation targeters care about the exchange rate?," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1590-1617.
    4. Nicoletta Batini & Vasco J. Gabriel & Paul Levine & Joseph Pearlman, 2010. "A Floating versus Managed Exchange Rate Regime in a DSGE Model of India," NIPE Working Papers, NIPE - Universidade do Minho 31/2010, NIPE - Universidade do Minho.
    5. Jaromir Benes & Andrew Berg & Rafael A Portillo & David Vavra, 2013. "Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework," IMF Working Papers 13/11, International Monetary Fund.
    6. Chayawadee Chai-anant & Runchana Pongsaparn & Kessarin Tansuwanarat, 2008. "Roles of Exchange Rate in Monetary Policy under Inflation Targeting: A Case Study for Thailand," Working Papers 2008-03, Economic Research Department, Bank of Thailand.
    7. 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.
    8. Carlos Garcia & Jorge Restrepo & Scott Roger, 2009. "Hybrid Inflation Targeting Regimes," IMF Working Papers 09/234, International Monetary Fund.
    9. Carlos Garcia & Jorge Restrepo & Scott Roger, 2009. "Hybrid Inflation Targeting Regimes1," ILADES-Georgetown University Working Papers, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines inv226, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
    10. Fredj Jawadi & Sushanta K. Mallick & Ricardo M. Sousa, 2011. "Fiscal Policy in the BRICs," NIPE Working Papers, NIPE - Universidade do Minho 19/2011, NIPE - Universidade do Minho.
    11. Fredj Jawadi & Sushanta K. Mallick & Ricardo M. Sousa, 2011. "Monetary Policy Rules in the BRICS: How Important is Nonlinearity?," NIPE Working Papers, NIPE - Universidade do Minho 18/2011, NIPE - Universidade do Minho.
    12. Javier García-Cicco, 2010. "Estimating Models for Monetary Policy Analysis in Emerging Countries," Working Papers Central Bank of Chile 561, Central Bank of Chile.
    13. PIROVANO, Mara, 2013. "International financial integration, credit frictions and exchange rate regimes," Working Papers 2013015, University of Antwerp, Faculty of Applied Economics.
    14. Alejandro Justiniano & Bruce Preston, 2009. "Monetary policy and uncertainty in an empirical small open economy model," Working Paper Series, Federal Reserve Bank of Chicago WP-09-21, Federal Reserve Bank of Chicago.
    15. Paul Levine & Joseph Pearlman & Nicoletta Batini, 2009. "Monetary and Fiscal Rules in an Emerging Small Open Economy," IMF Working Papers 09/22, International Monetary Fund.
    16. Nicoletta Batini & Paul Levine & Emanuela Lotti & Bo Yang, 2011. "Informality, Frictions and Monetary Policy," School of Economics Discussion Papers, School of Economics, University of Surrey 0711, School of Economics, University of Surrey.

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