Optimal Monetary Policy in a Currency Union with Interest Rate Spreads

49 Pages Posted: 4 Apr 2013 Last revised: 31 Jul 2015

See all articles by Saroj Bhattarai

Saroj Bhattarai

Pennsylvania State University - Department of Economics

Jae Won Lee

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences - New Brunswick/Piscataway - Department of Economics

Woong Yong Park

Seoul National University

Date Written: June 30, 2013

Abstract

We introduce "financial imperfections" -- asymmetric net wealth positions, incomplete risk-sharing, and interest rate spreads across member countries -- in a prototypical two-country currency union model and study implications for monetary policy transmission mechanism and optimal policy. In addition to, and independent from, the standard transmission mechanism associated with nominal rigidities, financial imperfections introduce a wealth redistribution role for monetary policy. Moreover, the two mechanisms reinforce each other and amplify the effects of monetary policy. On the normative side, financial imperfections, via interactions with nominal rigidities, generate two novel policy trade-offs. First, the central bank needs to pay attention to distributional efficiency in addition to macroeconomic (and price level) stability, which implies that a strict inflation targeting policy of setting union-wide inflation to zero is never optimal. Second, the interactions lead to a trade-off in stabilizing relative consumption versus the relative price gap (the deviation of relative prices from their efficient level) across countries, which implies that the central bank allows for less flexibility in relative prices. Finally, we consider how the central bank should respond to a financial shock that causes an increase in the interest rate spread. Under optimal policy, the central bank strongly decreases the deposit rate, which reduces aggregate and distributional inefficiencies by mitigating the drop in output and inflation and the rise in relative consumption and prices. Such a policy response can be well approximated by a spread-adjusted Taylor rule as it helps the real interest rate track the efficient rate of interest.

Keywords: Currency union, Optimal monetary policy, Redistributive monetary policy, Financial frictions, Interest rate spreads, Spread-adjusted Taylor rule

JEL Classification: E31, E51, E52, E61, F33, F41

Suggested Citation

Bhattarai, Saroj and Lee, Jae Won and Park, Woong Yong, Optimal Monetary Policy in a Currency Union with Interest Rate Spreads (June 30, 2013). Available at SSRN: https://ssrn.com/abstract=2245357 or http://dx.doi.org/10.2139/ssrn.2245357

Saroj Bhattarai

Pennsylvania State University - Department of Economics ( email )

Harrisburg, PA
United States

Jae Won Lee

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences - New Brunswick/Piscataway - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

Woong Yong Park (Contact Author)

Seoul National University ( email )

Kwanak-gu
Seoul, 151-742
Korea, Republic of (South Korea)

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