External Shocks, Banks and Monetary Policy in an Open Economy: Loss Function Approach

We systematically document that the 2007-09 financial crisis exposed emerging market economies (EMEs) to an adverse feedback loop of capital outflows, depreciating exchange rates, deteriorating balance sheets, rising credit spreads and falling real economic activity. Using a medium-scale New Keynesian DSGE model of a small open economy augmented with a banking sector that has access to both domestic and foreign funds, we explore the quantitative performances of alternative augmented IT rules in terms of macroeconomic and financial stabilization. In response to external financial shocks, credit-augmented IT rules are found to outperform output and exchange rate augmented rules in achieving policy mandates that target financial and external stability. A countercyclical reserve requirement policy that positively responds to the noncore liabilities share is found effective especially in coordination with monetary policy in reducing the procyclicality of the financial system.