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Optimal monetary policy in a small open economy with financial frictions

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  • Merola, Rossana

Abstract

I analyze how the introduction of financial frictions can affect the trade-off between output stabilization and inflation stability and whether, in the presence of financial frictions, the optimal outcome can be realized or approached more closely if monetary policy is allowed to react to aggregate financial variables. Moreover, I explore the issue of whether an inflation targeting cum exchange rate stabilization and a price-level targeting are more suitable rules in minimizing distortions generated by the presence of liabilities defined in foreign currency and in nominal terms. I find that, when the financial accelerator mechanism is working, a price-level targeting rule dominates. One caveat is that the source of the shock plays an important role. Once the financial shock is not operative, the gain from a price-level targeting rule decreases significantly. --

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Bibliographic Info

Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2010,01.

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Date of creation: 2010
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Handle: RePEc:zbw:bubdp1:201001

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Keywords: Monetary policy; Taylor rule; financial accelerator; price-level targeting; asset prices;

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Cited by:
  1. Scott Davis & Kevin X.D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization and Monetary Policy Institute Working Paper 85, Federal Reserve Bank of Dallas.
  2. PIROVANO, Mara, 2013. "International financial integration, credit frictions and exchange rate regimes," Working Papers 2013015, University of Antwerp, Faculty of Applied Economics.
  3. Ahmed, Waqas & Khan, Sajawal & Rehman, Muhammad, 2013. "Optimal Monetary Policy in the Presence of an Informal Sector and Firm-Level Credit Constraints," MPRA Paper 53169, University Library of Munich, Germany.
  4. 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.

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