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Monetary Policy in Illiquid Markets: Options for a Small Open Economy

  • Edda Claus
  • Mardi Dungey
  • Renée Fry


Two impediments to effective monetary policy operation include illiquidity in bond markets and the move towards the zero bound of interest rates. Either or both of these scenarios have been evident in many countries in the last decade, raising the suggestion that alternative means of enacting monetary policy may be required. This paper empirically explores policy options implemented through equity and currency markets that will generate similar inflation responses at a short (2 year) and a long (10 year) time frame as those obtained under current arrangements. The results show that current monetary policy arrangements are least costly in terms of the output loss from achieving lower inflation outcomes. However, if this option ceases to be available the next best alternative is to use the equity market option provided a longer run focus is maintained. Focus on short horizons increases the longer term output costs of the policy in all cases.

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Article provided by Springer in its journal Open Economies Review.

Volume (Year): 19 (2008)
Issue (Month): 3 (July)
Pages: 305-336

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Handle: RePEc:kap:openec:v:19:y:2008:i:3:p:305-336
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