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Financial Frictions and Optimal Monetary Policy in an Open Economy

Author

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  • Marcin Kolasa

    (Narodowy Bank Polski and Warsaw School of Economics)

  • Giovanni Lombardo

    (European Central Bank)

Abstract

We study welfare-based monetary policy in a two-country DSGE model characterized by financial frictions. We compare the cooperative Ramsey monetary policy with standard policy benchmarks as well as with the optimal Ramsey policy in a currency area. Our main results are the following. First, strict PPI targeting becomes excessively procyclical in response to productivity shocks in the presence of financial frictions. Second, foreign-currency debt denomination affects the optimal monetary policy and has important implications for exchange rate regimes. Third, we find that central banks should allow for deviations from price stability to offset the effects of balance sheet shocks. Fourth, while financial frictions substantially decrease attractiveness of all price-targeting regimes, they do not have a significant effect on the performance of a monetary union agreement. We show that the twocountry perspective offers new insights on the trade-offs faced by the monetary authority. For example, exchange rate adjustments tend to introduce a wedge between the external cost of finance across countries and, hence, they make the cooperative goal of return equalization a more difficult task.

Suggested Citation

  • Marcin Kolasa & Giovanni Lombardo, 2014. "Financial Frictions and Optimal Monetary Policy in an Open Economy," International Journal of Central Banking, International Journal of Central Banking, vol. 10(1), pages 43-94, March.
  • Handle: RePEc:ijc:ijcjou:y:2014:q:1:a:2
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    References listed on IDEAS

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    Cited by:

    1. Brzoza-Brzezina, Michał & Kolasa, Marcin & Makarski, Krzysztof, 2015. "A penalty function approach to occasionally binding credit constraints," Economic Modelling, Elsevier, vol. 51(C), pages 315-327.
    2. Engel, Charles, 2016. "International coordination of central bank policy," Journal of International Money and Finance, Elsevier, vol. 67(C), pages 13-24.
    3. Brzoza-Brzezina, Michał & Kolasa, Marcin & Makarski, Krzysztof, 2013. "The anatomy of standard DSGE models with financial frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 37(1), pages 32-51.
    4. Corsetti, Giancarlo & Kuester, Keith & Müller, Gernot, 2016. "The Case for Flexible Exchange Rates in a Great Recession," CEPR Discussion Papers 11432, C.E.P.R. Discussion Papers.
    5. PIROVANO, Mara, 2013. "International financial integration, credit frictions and exchange rate regimes," Working Papers 2013015, University of Antwerp, Faculty of Applied Economics.
    6. Michal Brzoza-Brzezina, 2014. "Financial Frictions and Macroprudential Policy," International Journal of Central Banking, International Journal of Central Banking, vol. 10(2), pages 249-261, June.
    7. Banerjee, Ryan & Devereux, Michael B. & Lombardo, Giovanni, 2016. "Self-oriented monetary policy, global financial markets and excess volatility of international capital flows," Journal of International Money and Finance, Elsevier, vol. 68(C), pages 275-297.
    8. Brzoza-Brzezina, Michał & Kolasa, Marcin & Makarski, Krzysztof, 2017. "Monetary and macroprudential policy with foreign currency loans," Journal of Macroeconomics, Elsevier, vol. 54(PB), pages 352-372.
    9. Marc Pourroy & Benjamin Carton & Dramane Coulibaly, 2016. "Food Prices and Inflation Targeting in Emerging Economies," International Economics, CEPII research center, issue 146, pages 108-140.
    10. 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.
    11. Daria Finocchiaro & Giovanni Lombardo & Caterina Mendicino & Philippe Weil, 2015. "Optimal inflation with corporate taxation and financial constraints," BIS Working Papers 520, Bank for International Settlements.
    12. McNelis, Paul D., 2016. "Optimal policy rules at home, crisis and quantitative easing abroad," BOFIT Discussion Papers 15/2016, Bank of Finland, Institute for Economies in Transition.
    13. Kilponen, Juha & Orjasniemi, Seppo & Ripatti, Antti & Verona, Fabio, 2016. "The Aino 2.0 model," Research Discussion Papers 16/2016, Bank of Finland.
    14. Michał Brzoza‐Brzezina & Marcin Kolasa, 2013. "Bayesian Evaluation of DSGE Models with Financial Frictions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(8), pages 1451-1476, December.
    15. Maurice Obstfeld, 2015. "Trilemmas and Tradeoffs: Living with Financial Globalization," Central Banking, Analysis, and Economic Policies Book Series,in: Claudio Raddatz & Diego Saravia & Jaume Ventura (ed.), Global Liquidity, Spillovers to Emerging Markets and Policy Responses, edition 1, volume 20, chapter 2, pages 013-078 Central Bank of Chile.
    16. Caterina Mendicino, 2014. "House prices and expectations," Research Bulletin, European Central Bank, vol. 21, pages 12-15.
    17. Mara Pirovano, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Paper Research 246, National Bank of Belgium.
    18. Pierre-Richard Agénor & Pengfei Jia, 2017. "Macroprudential Policy Coordination in a Currency Union'," Centre for Growth and Business Cycle Research Discussion Paper Series 235, Economics, The Univeristy of Manchester.
    19. Viktors Ajevskis & Kristine Vitola, 2011. "Housing and Banking in a Small Open Economy DSGE Model," Working Papers 2011/03, Latvijas Banka.
    20. Dedola, Luca & Karadi, Peter & Lombardo, Giovanni, 2013. "Global implications of national unconventional policies," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 66-85.
    21. Paloma Lopez-Garcia & Filippo di Mauro, 2014. "Assessing competitiveness: initial results from the new compnet micro-based database," Research Bulletin, European Central Bank, vol. 21, pages 2-7.
    22. Benjamin Schwanebeck, 2017. "Unconventional Monetary Policy in a Financially Heterogeneous Monetary Union," MAGKS Papers on Economics 201741, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).
    23. Sebastian Schmidt, 2014. "Dealing with a liquidity trap when government debt matters," Research Bulletin, European Central Bank, vol. 21, pages 8-11.
    24. Yasin Mimir & Enes Sunel, 2015. "External shocks, banks and optimal monetary policy in an open economy," BIS Working Papers 528, Bank for International Settlements.
    25. Nikolay Hristov, 2016. "The Ifo DSGE Model for the German Economy," ifo Working Paper Series 210, ifo Institute - Leibniz Institute for Economic Research at the University of Munich.

    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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