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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. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  2. Adrián Armas & Francisco Grippa, 2005. "Targeting Inflation in a Dollarized Economy: The Peruvian Experience," IDB Publications 6827, Inter-American Development Bank.
  3. 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.
  4. Nouriel Roubini & Michele Cavallo & Kate Kisselev, 2004. "Exchange rate overshooting and the costs of floating," Computing in Economics and Finance 2004 62, Society for Computational Economics.
  5. Eduardo Moron & Diego Winkelried, 2002. "Monetary Policy Rules for Financially Vulnerable EconomieEd," Macroeconomics 0205001, EconWPA.
  6. Charles Goodhart, 2005. "The Future of Central Banking," FMG Special Papers sp162, Financial Markets Group.
  7. Jeffrey A. Frankel, 2005. "Contractionary Currency Crashes in Developing Countries," NBER Working Papers 11508, National Bureau of Economic Research, Inc.
  8. 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.
  9. 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.
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Cited by:
  1. Bigio, Saki, 2009. "Learning under Fear of Floating," Working Papers 2009-004, Banco Central de Reserva del Perú.

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