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Monetary Policy under Balance Sheet Uncertainty

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Author Info
Saki Bigio () (Econometric Modelling Unit Central Bank of Peru and UP)
Marco Vega (LSE and Central Bank of Peru)

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Abstract

A group of developing countries bear high rates of financial dollarisation. Under this circumstance, monetary-policy makers are uncertain about the presence and scale of potentially harmful effects that might appear because of balance sheet mismatches arising from high and unexpected depreciations of the domestic currency. We build a setup whereby central bankers have two competing models in mind. Model A is a standard model for a small open economy whereas Model B has a builtin non-linear balance sheet effect. Whether the balance sheet mismatch problem exists or not, a Bayesian optimization procedure that assigns a positive probability to Model B, perpetuates model-indeterminacy. This happens because the optimal Bayesian regulator does not allow sizeable exchange rate swings (dirty floating), and therefore blurs the information to distinguish among models. We call this effect the Balance Sheet Trap. We show that, given the presence of the Balance Sheet Trap, introducing the learning dynamics into the central banker’s problem is optimal. Thus, we argue that intentional policy experimentation is highly desirable since it provides for an escape to the Balance Sheet Trap

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 157.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:157

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Find related papers by JEL classification:
C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Bayesian Analysis
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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  1. Nouriel Roubini & Michele Cavallo & Kate Kisselev, 2004. "Exchange rate overshooting and the costs of floating," 2004 Meeting Papers 766, Society for Economic Dynamics. [Downloadable!]
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  2. Charles Goodhart, 2005. "The Future of Central Banking," FMG Special Papers sp162, Financial Markets Group. [Downloadable!] (restricted)
  3. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May. [Downloadable!] (restricted)
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  4. Amartya Lahiri & Carlos A. Vegh, 2001. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Working Papers 8391, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Fukuda, Shin-ichi & Hoshi, Takeo & Ito, Takatoshi & Rose, Andrew, 2006. "International Finance," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 455-458, December. [Downloadable!] (restricted)
  6. Moron, Eduardo & Winkelried, Diego, 2005. "Monetary policy rules for financially vulnerable economies," Journal of Development Economics, Elsevier, vol. 76(1), pages 23-51, February. [Downloadable!] (restricted)
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  7. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government. [Downloadable!]
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  8. Adrián Armas & Francisco Grippa, 2005. "Targeting Inflation in a Dollarized Economy: The Peruvian Experience," RES Working Papers 4423, Inter-American Development Bank, Research Department. [Downloadable!]
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