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Monetary policy in a world with different financial systems

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  • Faia, Ester

Abstract

Major currency areas are characterized by important differences in financial structure that are clear in microeconomic data. Surprisingly, this fact is seldom discussed in the analysis of the international transmission of shocks. This paper attempts to fill the gap. First, I show some stylized facts about financial differences and cyclical correlations among the main OECD countries. Second, using a two-country model with monopolistic competition and sticky prices, calibrated to US and euro area data, I analyze the international transmission of shocks with different degrees of financial fragility in the two economies. I find, first, that financial diversity can account for heterogenous business cycle fluctuations. Differential responses to shocks are shown to occur with independent monetary policies - Taylor rules or rigid inflation targets - even with low degrees of economic and financial openness. Credible pegs help to increase the synchronization of cycles. Secondly, differences in persistence of the interest rates help to explain high persistence in the real exchange rate. Finally, weak financial systems can result in large welfare losses under symmetric and correlated shocks. JEL Classification: E3, E42, E44, E52, F41

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Paper provided by European Central Bank in its series Working Paper Series with number 0183.

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Date of creation: Oct 2002
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Handle: RePEc:ecb:ecbwps:20020183

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Keywords: differential transmission mechanism; Financial diversity; financial stability; monetary regimes; welfare losses;

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Citations

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Cited by:
  1. Virginia Queijo, 2005. "Bayesian Estimation of a DSGE Model with Financial Frictions for the U.S. and the Euro Area," Computing in Economics and Finance 2005, Society for Computational Economics 306, Society for Computational Economics.
  2. Queijo, Virginia, 2005. "How Important are Financial Frictions in the U.S. and Euro Area?," Seminar Papers, Stockholm University, Institute for International Economic Studies 738, Stockholm University, Institute for International Economic Studies.
  3. De Fiore, Fiorella & Uhlig, Harald, 2005. "Bank Finance versus Bond Finance: What Explains the Differences Between the US and Europe?," CEPR Discussion Papers 5213, C.E.P.R. Discussion Papers.
  4. Ester Faia, 2007. "Financial Differences and Business Cycle Co-Movements in a Currency Area," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 39(1), pages 151-185, 02.
  5. Buch, Claudia M. & Pierdzioch, Christian, 2005. "The integration of imperfect financial markets: Implications for business cycle volatility," Journal of Policy Modeling, Elsevier, Elsevier, vol. 27(7), pages 789-804, October.
  6. Badarau, Cristina & Levieuge, Grégory, 2011. "Assessing the effects of financial heterogeneity in a monetary union a DSGE approach," Economic Modelling, Elsevier, vol. 28(6), pages 2451-2461.
  7. de Blas, Beatriz, 2008. "International Transmission of Shocks under Financial Frictions: Some Implications for International Business Cycle Comovement," Working Papers in Economic Theory 2008/01, Universidad Autónoma de Madrid (Spain), Department of Economic Analysis (Economic Theory and Economic History).
  8. Bojan Markovic, 2006. "Bank capital channels in the monetary transmission mechanism," Bank of England working papers 313, Bank of England.
  9. Florina-Cristina Badarau & Grégory Levieuge, 2011. "Which policy-mix to mitigate the effects of financial heterogeneity in a monetary union?," Working Papers hal-00641995, HAL.
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  11. Ferro, Gustavo, 2007. "Metas de inflación ¿qué hay de nuevo bajo el sol?
    [Inflation Targeting. What's new under the sun?]
    ," MPRA Paper 15069, University Library of Munich, Germany, revised 11 Mar 2008.
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