Financial Frictions in the Small Open Economy

This paper introduces a global banking system in a small open economy DSGE model with financialfrictions. The model features global relative price adjustments with incomplete asset market. Three mainfindings stand out. Firstly, foreign financial shocks capture negative spillovers from foreign country ina global financial crisis. We show that country differences in the severity of the shocks depend on thedegree of trade openness and banking system stability. Secondly, credit policy could be more powerfulthan monetary policy to alleviate foreign financial shocks since an expansionary monetary policy andalternative policy rules are not a sufficient tool in the global financial crisis. In particular, credit policybased on international credit spread outperforms credit policy based on domestic credit spread since thelatter leads to “excess smoothness†in the real exchange rate. Lastly, foreign credit policy has a negligibleinfluence on domestic welfare so that the small open economy can effectively reduce welfare losses onlyif the central bank in the economy injects credit.