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Financial globalization, financial frictions and optimal monetary policy

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  • Ester Faia
  • Eleni Iliopulos

Abstract

How should monetary policy be optimally designed in an environment with high degrees of financial globalization? To answer this question we lay down an open economy model where net lending toward the rest of the world is constrained by a collateral constraint motivated by limited enforcement. Borrowing is secured by collateral in the form of durable goods whose accumulation is subject to adjustment costs. We demonstrate that, although this economy can generate persistent current account deficits, it can also deliver a stationary equilibrium. The comparison between different monetary policy regimes (floating versus pegged) shows that the impossible trinity is reversed: a higher degree of financial globalization, by inducing more persistent and volatile current account deficits, calls for exchange rate stabilization. Finally, we study the design of optimal (Ramsey) monetary policy. In this environment the policy maker faces the additional goal of stabilizing exchange rate movements, which exacerbate fluctuations in the wedges induced by the collateral constraint. In this context optimality requires deviations from price stability and calls for exchange rate stabilization.

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Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 52.

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Date of creation: 2010
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Handle: RePEc:fip:feddgw:52

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Keywords: Monetary policy ; Globalization ; International finance ; Foreign exchange rates ; Financial stability ; International trade;

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Cited by:
  1. 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.
  2. Aliya Algozhina, 2012. "Monetary and Fiscal Policy Interactions in an Emerging Open Economy: a Non-Ricardian DSGE Approach," FIW Working Paper series 094, FIW, revised Dec 2012.

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