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Monetary Policy under Balance Sheet Uncertainty

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  • Saki Bigio

    ()
    (Econometric Modelling Unit Central Bank of Peru and UP)

  • Marco Vega

    (LSE and Central Bank of Peru)

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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File URL: http://repec.org/sce2006/up.24977.1140025612.pdf
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Bibliographic Info

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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  1. Eduardo Morón & Diego Winkelried, 2003. "Monetary Policy Rules for Financially Vulnerable Economies," IMF Working Papers 03/39, International Monetary Fund.
  2. Charles Goodhart, 2005. "The Future of Central Banking," FMG Special Papers sp162, Financial Markets Group.
  3. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  4. Nouriel Roubini & Michele Cavallo & Kate Kisselev, 2004. "Exchange rate overshooting and the costs of floating," 2004 Meeting Papers 766, Society for Economic Dynamics.
  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.
  6. Michele Cavallo & Kate Kisselev & Fabrizio Perri & Nouriel Roubini, 2005. "Exchange rate overshooting and the costs of floating," Working Paper Series 2005-07, Federal Reserve Bank of San Francisco.
  7. Adrián Armas & Francisco Grippa, 2005. "Targeting Inflation in a Dollarized Economy: The Peruvian Experience," Research Department Publications 4423, Inter-American Development Bank, Research Department.
  8. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government.
  9. Amartya Lahiri & Carlos A. Végh, 2002. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 663-704 National Bureau of Economic Research, Inc.
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Cited by:
  1. Bigio, Saki, 2010. "Learning under fear of floating," Journal of Economic Dynamics and Control, Elsevier, vol. 34(10), pages 1923-1950, October.

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