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Financial Intermediation and Monetary Policy in a Small Open Economy

  • Juan David Prada Sarmiento


This paper analyses the role of a costly financial system in the transmission of monetarypolicy. The new-keynesian model for a small open economy is extended with asimple financial system based in Hamann and Oviedo (2006). The presence of the financialintermediation naturally allows the introduction of standard policy instruments: therepo interest rate and the compulsory requirement of reserves. The model is calibrated tomatch key steady-state ratios of Colombia and is used to evaluate the alternative policyinstruments. The financial system plays an important role in the transmission mechanismof the monetary policy, and determines the final effects on aggregated demand andinflation rates of exogenous modifications of the policy instruments. The monetary policyconducted through the repo interest rate has the standard effects predicted by thenew-keynesian framework. But changes in the compulsory reserve requirement rate maygenerate, under different scenarios, totally different reactions on economic activity, andlittle quantitative effects on inflation rates and aggregate demand. Therefore this lastpolicy instrument appears to be uneffective and unreliable.

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Paper provided by BANCO DE LA REPÚBLICA in its series BORRADORES DE ECONOMIA with number 005010.

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Length: 46
Date of creation: 22 Sep 2008
Date of revision:
Handle: RePEc:col:000094:005010
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  1. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  2. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June.
  3. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2001. "External constraints on monetary policy and the financial accelerator," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  4. Villar Gómez Leonardo & David M. Salamanca Rojas & Andrés Murcia Pabón, 2005. "Crédito, represión financiera y flujos de capitales en Colombia: 1974-2003," REVISTA DESARROLLO Y SOCIEDAD, UNIVERSIDAD DE LOS ANDES-CEDE, May.
  5. Martha R. López & Juan D. Prada & Norberto Rodríguez N., . "Financial Accelerator Mechanism in a Small Open Economy," Borradores de Economia 525, Banco de la Republica de Colombia.
  6. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  7. Edwards, Sebastian & Vegh, Carlos A., 1997. "Banks and macroeconomic disturbances under predetermined exchange rates," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 239-278, October.
  8. Andrea Gerali & Stefano Neri & Luca Sessa & Federico M. Signoretti, 2010. "Credit and Banking in a DSGE Model of the Euro Area," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 107-141, 09.
  9. Oviedo, P. Marcelo, 2005. "World Interest Rate, Business Cycles, and Financial Intermediation in Small Open Economies," Staff General Research Papers 12360, Iowa State University, Department of Economics.
  10. Brock, Philip L, 1989. "Reserve Requirements and the Inflation Tax," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(1), pages 106-21, February.
  11. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  12. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  13. Andrés González & Lavan Mahadeva & Juan D. Prada & Diego Rodríguez, 2011. "Policy Analysis Tool Applied to Colombian Needs: PATACON Model Description," BORRADORES DE ECONOMIA 008698, BANCO DE LA REPÚBLICA.
  14. Romer, David, 1985. "Financial intermediation, reserve requirements, and inside money: A general equilibrium analysis," Journal of Monetary Economics, Elsevier, vol. 16(2), pages 175-194, September.
  15. Ben S. Bernanke, 1983. "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression," NBER Working Papers 1054, National Bureau of Economic Research, Inc.
  16. Andrés Felipe Arias, 2000. "The Colombian Banking Crisis: Macroeconomic Consequences And What To Expect," BORRADORES DE ECONOMIA 003573, BANCO DE LA REPÚBLICA.
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