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Monetary Rules in Emerging Economies with Financial Market Imperfections

Listed author(s):
  • Nicoletta Batini

    (International Monetary Fund)

  • Paul Levine

    (University of Surrey)

  • Joseph Pearlman

    (London Metropolitan University)

We build a two-bloc emerging market - rest of the world model. The emerging market bloc incorporates partial transactions and liability dollarization, as well as financial frictions including a ‘financial accelerator’, where capital financing is partly or totally in foreign currency as in Gertler et al. (2003) and Gilchrist (2003)). Simulations of the model under various ‘operational’ monetary policy rules derived assuming that the central bank maximizes households’ utility point to important results. First, we reaffirm the finding in the literature that financial frictions, especially when coupled with liability dollarization, severely increase the costs of a fixed exchange rate regime. By contrast, transactions dollarization has only a small impact on the choice of the monetary regime. Second, central banks in emerging economies with these frictions should not explicitly target the exchange rate; nor should they implicitly do so by choosing a CPI rather than domestic price inflation target. Third, with dollarization and frictions, the zero lower bound constraint on the nominal interest rate makes simple Taylor-type rules perform much worse in terms of stabilization performance than fully optimal monetary policy.

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File URL: http://www.fahs.surrey.ac.uk/economics/discussion_papers/2007/DP08-07.pdf
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Paper provided by School of Economics, University of Surrey in its series School of Economics Discussion Papers with number 0807.

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Length: 66 pages
Date of creation: Oct 2007
Handle: RePEc:sur:surrec:0807
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  1. Coenen, Günter & Wieland, Volker, 2003. "The Zero-Interest Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," CEPR Discussion Papers 3895, C.E.P.R. Discussion Papers.
  2. Eduardo Levy-Yeyati, 2004. "FINANCIAL DOLLARIZATION: Evaluating the consequences," Econometric Society 2004 Latin American Meetings 184, Econometric Society.
  3. Guillermo A. Calvo & Frederic S. Mishkin, 2003. "The Mirage of Exchange Rate Regimes for Emerging Market Countries," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 99-118, Fall.
  4. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 199-216, March.
  5. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Working Papers 11523, National Bureau of Economic Research, Inc.
  6. Levine, Paul & McAdam, Peter & Pearlman, Joseph G., 2007. "Quantifying and sustaining welfare gains from monetary commitment," Working Paper Series 0709, European Central Bank.
  7. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2003. "External constraints on monetary policy and the financial accelerator," BIS Working Papers 139, Bank for International Settlements.
  8. Kosuke Aoki & Takeshi Kimura, 2007. "Uncertainty about Perceived Inflation Target and Monetary Policy," Bank of Japan Working Paper Series 07-E-16, Bank of Japan.
  9. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2003. "Indeterminacy with inflation-forecast-cased rules in a two-bloc model," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages -.
  10. Adam, Klaus & Billi, Roberto M., 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," CFS Working Paper Series 2005/16, Center for Financial Studies (CFS).
  11. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
  12. Nicoletta Batini & Richard Harrison & Stephen P Millard, 2001. "Monetary policy rules for an open economy," Bank of England working papers 149, Bank of England.
  13. Kempf, Hubert & Gilchrist, Simon & Hairault, Jean-Olivier, 2002. "Monetary policy and the financial accelerator in a monetary union," Working Paper Series 0175, European Central Bank.
  14. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
  15. Eggertsson, Gauti B., 2006. "The Deflation Bias and Committing to Being Irresponsible," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 283-321, March.
  16. Benigno, Gianluca & Benigno, Pierpaolo, 2008. "Exchange rate determination under interest rate rules," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 971-993, October.
  17. Pierpaolo Benigno, 2008. "Price stability with imperfect financial integration," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages -.
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