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Financial Frictions and Optimal Monetary Policy in an Open Economy

National Bank of Poland Working Paper No. 91

42 Pages Posted: 4 Aug 2011 Last revised: 8 Jul 2016

Marcin Kolasa

National Bank of Poland; Warsaw School of Economics (SGH)

Giovanni Lombardo

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: July 1, 2011

Abstract

A growing number of papers have studied positive and normative implications of financial frictions in DSGE models. We contribute to this literature by studying the welfare-based monetary policy in a two-country model characterized by financial frictions, alongside a number of key features, like capital accumulation, non-traded goods and foreign-currency debt denomination. We compare the cooperative Ramsey monetary policy with standard policy benchmarks (e.g. PPI stability) as well as with the optimal Ramsey policy in a currency area. We show that the two-country perspective offers new insights on the trade-offs faced by the monetary authority. Our main results are the following. First, strict PPI targeting (nearly optimal in our model if credit frictions are absent) becomes excessively procyclical in response to positive productivity shocks in the presence of financial frictions. The related welfare losses are non-negligible, especially if financial imperfections interact with non-tradable production. Second, (asymmetric) foreign currency debt denomination affects the optimal monetary policy and has important implications for exchange rate regimes. In particular, the larger the variance of domestic productivity shocks relative to foreign, the closer the PPI-stability policy is to the optimal policy and the farther is the currency union case. Third, we find that central banks should allow for deviations from price stability to offset the effects of balance sheet shocks. Finally, while financial frictions substantially decrease attractiveness of all price targeting regimes, they do not have a significant effect on the performance of a monetary union agreement.

Keywords: financial frictions, open economy, optimal monetary policy

JEL Classification: E52, E61, E44, F36, F41

Suggested Citation

Kolasa, Marcin and Lombardo, Giovanni, Financial Frictions and Optimal Monetary Policy in an Open Economy (July 1, 2011). National Bank of Poland Working Paper No. 91. Available at SSRN: https://ssrn.com/abstract=1904841 or http://dx.doi.org/10.2139/ssrn.1904841

Marcin Kolasa (Contact Author)

National Bank of Poland ( email )

00-919 Warsaw
Poland

Warsaw School of Economics (SGH) ( email )

Niepodleglosci 162
PL-Warsaw, 02-554
Poland

Giovanni Lombardo

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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