Household and firm leverage, capital flows and monetary policy in a small open economy

This paper presents a framework to analyze the interplay between ?financial frictions at the household and firm level, liability dollarization and monetary policy in a small open economy subject to productivity and capital inflow shocks. Optimized monetary policy rules are calculated under several specifications (inflation targeting, exchange rate targeting, fixed exchange rate, credit growth targeting) and for two central banks objectives (macroeconomic stability and macroeconomic plus financial stability). I ?find that, first, adding ?financial stability to the central banks objectives results in more inertial monetary policy rules. Second, the optimized Taylor rules under the ?financial stability objective achieve a lower volatility of inflation and of credit growth at the same time. However, this comes at the expense of a higher standard deviation of production. Third, when ?financial stability is included among the central banks objectives, engaging in exchange rate smoothing delivers the smallest value of the central banks loss function, mainly arising through a much reduced volatility of the credit aggregate. In the considered economy, credit growth targeting is suboptimal because of the effect of stronger interest rate increase on currency fluctuations, which reinforce the ?financial accelerator. Finally, for the considered shocks, the extent of co-movement of financial variables pertaining to entrepreneurs and homeowners crucially depends on the degree of exchange rate flexibility.