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Monetary policy in a world with different financial systems

  • Faia, Ester

Major currency areas are characterized by important differences in financial structure that are clear in microeconomic data. Surprisingly, this fact is seldom discussed in the analysis of the international transmission of shocks. This paper attempts to fill the gap. First, I show some stylized facts about financial differences and cyclical correlations among the main OECD countries. Second, using a two-country model with monopolistic competition and sticky prices, calibrated to US and euro area data, I analyze the international transmission of shocks with different degrees of financial fragility in the two economies. I find, first, that financial diversity can account for heterogenous business cycle fluctuations. Differential responses to shocks are shown to occur with independent monetary policies - Taylor rules or rigid inflation targets - even with low degrees of economic and financial openness. Credible pegs help to increase the synchronization of cycles. Secondly, differences in persistence of the interest rates help to explain high persistence in the real exchange rate. Finally, weak financial systems can result in large welfare losses under symmetric and correlated shocks. JEL Classification: E3, E42, E44, E52, F41

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Paper provided by European Central Bank in its series Working Paper Series with number 0183.

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Date of creation: Oct 2002
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Handle: RePEc:ecb:ecbwps:20020183
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