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Asset Prices and Financial Frictions in Monetary Transmission: The Case of Latvia

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  • Kristine Vitola
  • Ludmila Fadejeva

Abstract

The purpose of this paper is to quantify the role of financial frictions in Latvia's monetary transmission. Our model extends M. Iacoviello (9) framework along three dimensions. First, we introduce open-economy features by allowing imports of foreign consumer goods and borrowing from abroad. Second, we relax the assumption of fixed housing stock, allowing for investment. Finally, we assume a risk premium on foreign borrowing, which depends on net foreign asset position. We estimate the model by Bayesian approach and compare impulse responses to shocks under various scenarios. In addition to the baseline scenario, we explore the importance of tighter borrowing constraints and higher foreign risk premium elasticity in the model dynamics. Our findings show that tighter credit constraints weaken the transmission of shocks to housing demand and consumption. In the case of foreign interest rate and risk premium shocks, higher risk premium elasticity lessens the effect of monetary transmission on the domestic economy through higher cost of external funds.

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Bibliographic Info

Paper provided by Latvijas Banka in its series Working Papers with number 2010/03.

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Date of creation: 23 Dec 2010
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Handle: RePEc:ltv:wpaper:201003

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Keywords: financial frictions; monetary transmission; asset prices; DSGE model; Bayesian approach;

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  1. Matteo Iacoviello & Stefano Neri, 2010. "Housing Market Spillovers: Evidence from an Estimated DSGE Model," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(2), pages 125-64, April.
  2. Calza, Alessandro & Stracca, Livio & Monacelli, Tommaso, 2009. "Housing finance and monetary policy," Working Paper Series 1069, European Central Bank.
  3. Christiano, Lawrence J. & Trabandt, Mathias & Walentin, Karl, 2007. "Introducing Financial Frictions and Unemployment into a Small Open Economy Model," Working Paper Series 214, Sveriges Riksbank (Central Bank of Sweden), revised 01 Jun 2011.
  4. Viktors Ajevskis & Kristine Vitola, 2009. "Advantages of Fixed Exchange Rate Regime from a General Equilibrium Perspective," Working Papers 2009/04, Latvijas Banka.
  5. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  6. Andrea Gerali & Stefano Neri & Luca Sessa & Federico M. Signoretti, 2010. "Credit and Banking in a DSGE Model of the Euro Area," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 107-141, 09.
  7. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
  8. Zvi Hercowitz & Jeffrey C. Campbell, 2005. "The Role of Collateralized Household Debt in Macroeconomic Stabilization," 2005 Meeting Papers 120, Society for Economic Dynamics.
  9. Adolfson, Malin & Laséen, Stefan & Lindé, Jesper & Villani, Mattias, 2007. "Evaluating An Estimated New Keynesian Small Open Economy Model," Working Paper Series 203, Sveriges Riksbank (Central Bank of Sweden).
  10. Margarita Rubio, 2009. "Housing market heterogeneity in a monetary union," Banco de Espa�a Working Papers 0916, Banco de Espa�a.
  11. Ian Christensen & Paul Corrigan & Caterina Mendicino & Shin-Ichi Nishiyama, 2009. "Consumption, Housing Collateral, and the Canadian Business Cycle," Working Papers 09-26, Bank of Canada.
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