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A Simple Model of Optimal Monetary Policy with Financial Constraints

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  • Devereux, Michael B
  • Poon, Doris

Abstract

Recent experience suggests that the operation of monetary policy in emerging market economies is severely limited by the presence of financial constraints. This is seen in the tendency to follow contractionary monetary policy during crises, and the observation that these countries pursue much more stable exchange rates than do high income advanced economies, despite having a more volatile external environment. This Paper analyses the use of monetary policy in an open economy in which exchange rate sensitive collateral constraints may bind in some states of the world. The appeal of the model is that it allows for a complete analytical description of the effects of collateral constraints, and admits a full characterization of welfare-maximizing monetary policy rules. The model can explain the two empirical features of emerging market monetary policy described above – in particular, that optimal monetary policy may be pro-cyclical under binding collateral constraints, and an economy with large external shocks may favour a fixed exchange rate, even though flexible exchange rates are preferred when external shocks are smaller.

Suggested Citation

  • Devereux, Michael B & Poon, Doris, 2004. "A Simple Model of Optimal Monetary Policy with Financial Constraints," CEPR Discussion Papers 4370, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:4370
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    Citations

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    Cited by:

    1. Philip L. Brock, 2009. "Collateral Constraints and Macroeconomic Adjustment in an Open Economy," Working Papers UWEC-2009-03, University of Washington, Department of Economics.
    2. Yossi Yakhin, 2008. "Financial Integration And Cyclicality Of Monetary Policy In Small Open Economies," Working Papers 0811, Ben-Gurion University of the Negev, Department of 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. Shi, Kang & Xu, Juanyi, 2010. "Twin dollarization and exchange rate policy," Journal of International Economics, Elsevier, vol. 81(1), pages 109-121, May.
    5. Muhammad Ali Choudhary & Muhammad Nadim Hanif & Sajawal Khan & Muhammad Rehman, 2012. "Procyclical Monetary Policy and Governance," SBP Research Bulletin, State Bank of Pakistan, Research Department, vol. 8, pages 33-43.
    6. Duncan, Roberto, 2014. "Institutional quality, the cyclicality of monetary policy and macroeconomic volatility," Journal of Macroeconomics, Elsevier, vol. 39(PA), pages 113-155.
    7. Siok Kun, Sek, 2009. "The impacts of economic structures on the performance of simple policy rules in a small open economy," MPRA Paper 25065, University Library of Munich, Germany.

    More about this item

    Keywords

    collateral constraints; exchange rate; monetary policy;

    JEL classification:

    • F00 - International Economics - - General - - - General
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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