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Financial Globalization, Financial Frictions and Optimal Monetary Policy

  • Ester Faia

    ()

    (Goethe University Frankfurt - Department of Money and Macroeconomics, CEPREMAP - Centre pour la recherche économique et ses applications - Centre pour la recherche économique et ses applications)

  • Eleni Iliopulos

    ()

    (CEPREMAP - Centre pour la recherche économique et ses applications - Centre pour la recherche économique et ses applications, CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)

How should monetary policy be optimally designed in an environment with high degrees of financial globalization ? To answer this question we lay down an open economy model where net lending toward the rest of the world is constrained by a collateral constraint motivated by limited enforcement. Borrowing is secured by collateral in the form of durable goods whose accumulation is subject to adjustment costs. We demonstrate that, although this economy can generate persistent current account deficits, it can also deliver a stationary equilibrium. The comparison between different monetary policy regimes (floating versus pegged) shows that the impossible trinity is reversed : a higher degree of financial globalization, by inducing more persistent and volatile current account deficits, calls for exchange rate stabilization. Finally, we study the design of optimal (Ramsey) monetary policy. In this environment the policy maker faces the additional goal of stabilizing exchange rate movements, which exacerbate fluctuations in the wedges induced by the collateral constraint. In this context optimality requires deviations from price stability and calls for exchange rate stabilization.

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Paper provided by HAL in its series Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) with number halshs-00497486.

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Date of creation: Jun 2010
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Handle: RePEc:hal:cesptp:halshs-00497486
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