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Financial openness, financial frictions and optimal monetary policy

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  • Faia, Ester
  • Iliopulos, Eleni

Abstract

Increasing financial integration challenges the optimality of inward-looking strategies for optimal monetary policy. Those issues are analyzed in an open economy where foreign net lending, and the current account, are determined by a collateral constraint. Durables represent collateral. The current account features persistent imbalances, but can deliver a long run stationary equilibrium. The comparison between floating and managed exchange rate regimes shows that the impossible trinity is reversed: higher financial integration increases the persistence and volatility of the current account and calls for exchange rate stabilization. In this context, the Ramsey plan too prescribes stabilization of the exchange rate, alongside with domestic inflation.

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  • Faia, Ester & Iliopulos, Eleni, 2011. "Financial openness, financial frictions and optimal monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 35(11), pages 1976-1996.
    • Handle: RePEc:eee:dyncon:v:35:y:2011:i:11:p:1976-1996
    DOI: 10.1016/j.jedc.2011.06.012
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    3. Bosupeng, Mpho, 2015. "The Impossible Trinity and Financial Markets – An Examination of Inflation Volatility Spillovers," MPRA Paper 77923, University Library of Munich, Germany, revised 2015.
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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F1 - International Economics - - Trade

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