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Monetary Rules in Emerging Economies with Financial Market Imperfections

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Author Info

  • Nicoletta Batini

    (International Monetary Fund)

  • Paul Levine

    (University of Surrey)

  • Joseph Pearlman

    (London Metropolitan University)

Abstract

We build a two-bloc emerging market - rest of the world model. The emerging market bloc incorporates partial transactions and liability dollarization, as well as financial frictions including a ‘financial accelerator’, where capital financing is partly or totally in foreign currency as in Gertler et al. (2003) and Gilchrist (2003)). Simulations of the model under various ‘operational’ monetary policy rules derived assuming that the central bank maximizes households’ utility point to important results. First, we reaffirm the finding in the literature that financial frictions, especially when coupled with liability dollarization, severely increase the costs of a fixed exchange rate regime. By contrast, transactions dollarization has only a small impact on the choice of the monetary regime. Second, central banks in emerging economies with these frictions should not explicitly target the exchange rate; nor should they implicitly do so by choosing a CPI rather than domestic price inflation target. Third, with dollarization and frictions, the zero lower bound constraint on the nominal interest rate makes simple Taylor-type rules perform much worse in terms of stabilization performance than fully optimal monetary policy.

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Bibliographic Info

Paper provided by School of Economics, University of Surrey in its series School of Economics Discussion Papers with number 0807.

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Length: 66 pages
Date of creation: Oct 2007
Date of revision:
Handle: RePEc:sur:surrec:0807

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Keywords: monetary policy; emerging economies; dollarization; financial accelerator;

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References

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  1. Aoki, Kosuke & Kimura, Takeshi, 2007. "Uncertainty about perceived inflation target and monetary policy," Discussion Paper Series 1: Economic Studies 2007,18, Deutsche Bundesbank, Research Centre.
  2. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
  3. Andrew T. Levin & Alexei Onatski & John Williams & Noah M. Williams, 2006. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Chapters, in: NBER Macroeconomics Annual 2005, Volume 20, pages 229-312 National Bureau of Economic Research, Inc.
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  7. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 199-216, March.
  8. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2003. "External constraints on monetary policy and the financial accelerator," BIS Working Papers 139, Bank for International Settlements.
  9. Levine, Paul & McAdam, Peter & Pearlman, Joseph, 2008. "Quantifying and sustaining welfare gains from monetary commitment," Journal of Monetary Economics, Elsevier, vol. 55(7), pages 1253-1276, October.
  10. Batini, Nicoletta & Harrison, Richard & Millard, Stephen P., 2003. "Monetary policy rules for an open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 27(11-12), pages 2059-2094, September.
  11. Guillermo Calvo & Frederic S. Mishkin, 2003. "The Mirage of Exchange Rate Regimes for Emerging Market Countries," NBER Working Papers 9808, National Bureau of Economic Research, Inc.
  12. Eduardo Levy-Yeyati, 2004. "FINANCIAL DOLLARIZATION: Evaluating the consequences," Econometric Society 2004 Latin American Meetings 184, Econometric Society.
  13. Coenen, Günter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Working Paper Series 0218, European Central Bank.
  14. Benigno, Gianluca & Benigno, Pierpaolo, 2008. "Exchange rate determination under interest rate rules," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 971-993, October.
  15. Kempf, Hubert & Gilchrist, Simon & Hairault, Jean-Olivier, 2002. "Monetary policy and the financial accelerator in a monetary union," Working Paper Series 0175, European Central Bank.
  16. N. Batini & P. Levine & J. Pearlman, 2003. "Indeterminacy with inflation-forecast-cased rules in a two-bloc model," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  17. Klaus Adam & Roberto M. Billi, 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Research Working Paper RWP 05-08, Federal Reserve Bank of Kansas City.
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Citations

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Cited by:
  1. Nicoletta Batini & Vasco Gabriel & Paul Levine & Joseph Pearlman, 2010. "A Floating versus Managed Exchange Rate Regime in a DSGE Model of India," Macroeconomics Working Papers 21992, East Asian Bureau of Economic Research.
  2. Nicoletta Batini & Eugen Tereanu, 2009. "What Should Inflation Targeting Countries Do When Oil Prices Rise and Drop Fast?," IMF Working Papers 09/101, International Monetary Fund.
  3. Alejandro Justiniano & Bruce Preston, 2010. "Monetary policy and uncertainty in an empirical small open-economy model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 25(1), pages 93-128.
  4. Garcia, Carlos J. & Restrepo, Jorge E. & Roger, Scott, 2011. "How much should inflation targeters care about the exchange rate?," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1590-1617.
  5. PIROVANO, Mara, 2013. "International financial integration, credit frictions and exchange rate regimes," Working Papers 2013015, University of Antwerp, Faculty of Applied Economics.
  6. Carlos Garcia & Jorge Restrepo & Scott Roger, 2009. "Hybrid Inflation Targeting Regimes1," ILADES-Georgetown University Working Papers inv226, Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines.
  7. Levine, Paul & Pearlman, Joseph G. & Pierse, Richard, 2007. "Linear-quadratic approximation, external habit and targeting rules," Working Paper Series 0759, European Central Bank.
  8. Carlos Garcia & Jorge Restrepo & Scott Roger, 2009. "Hybrid Inflation Targeting Regimes," IMF Working Papers 09/234, International Monetary Fund.
  9. Chayawadee Chai-anant & Runchana Pongsaparn & Kessarin Tansuwanarat, 2008. "Roles of Exchange Rate in Monetary Policy under Inflation Targeting: A Case Study for Thailand," Working Papers 2008-03, Economic Research Department, Bank of Thailand.
  10. Jaromir Benes & Andrew Berg & Rafael A Portillo & David Vavra, 2013. "Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework," IMF Working Papers 13/11, International Monetary Fund.
  11. Nicoletta Batini & Paul Levine & Emanuela Lotti & Bo Yang, 2011. "Informality, Frictions and Monetary Policy," School of Economics Discussion Papers 0711, School of Economics, University of Surrey.
  12. Javier García-Cicco, 2010. "Estimating Models for Monetary Policy Analysis in Emerging Countries," Working Papers Central Bank of Chile 561, Central Bank of Chile.
  13. PIROVANO, Mara, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Papers 2013014, University of Antwerp, Faculty of Applied Economics.
  14. Fredj Jawadi & Sushanta K. Mallick & Ricardo M. Sousa, 2011. "Fiscal Policy in the BRICs," NIPE Working Papers 19/2011, NIPE - Universidade do Minho.
  15. Paul Levine & Joseph Pearlman & Nicoletta Batini, 2009. "Monetary and Fiscal Rules in an Emerging Small Open Economy," IMF Working Papers 09/22, International Monetary Fund.
  16. Fredj Jawadi & Sushanta K. Mallick & Ricardo M. Sousa, 2011. "Monetary Policy Rules in the BRICS: How Important is Nonlinearity?," NIPE Working Papers 18/2011, NIPE - Universidade do Minho.

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