Financial Frictions and Unconventional Monetary Policy in Emerging Economies

43 Pages Posted: 8 Feb 2016 Last revised: 28 Jun 2021

See all articles by Roberto Chang

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics; National Bureau of Economic Research (NBER)

Andrés Velasco

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Date Written: February 2016

Abstract

We analyze conventional and unconventional monetary policies in a dynamic small open-economy model with financial frictions. In the model, financial intermediaries or banks borrow from the world market and lend to domestic households. Banks can borrow abroad up to a multiple of their equity; in turn, there is a limit to how much bank equity households can hold. An economy-wide credit constraint and an endogenous interest rate spread emerge from this combination of external and domestic frictions. The resulting financial imperfections amplify the domestic effects of exogenous shocks and make those effects more persistent. In response to external balance shocks, fixed exchange rates are contractionary and flexible exchange rates expansionary (although less so in the presence of currency mismatches); the opposite is true in response to increases in the world interest rate. Unconventional policies, including central bank direct credit, discount lending, and equity injections to banks, have real effects only if financial constraints bind. Because of bank leverage, central bank discount lending and equity injections are more effective than direct credit. Sterilized foreign exchange intervention is equivalent to lending directly to domestic agents. Unconventional policies are feasible only to the extent that the central bank holds a sufficient amount of international reserves.

Suggested Citation

Chang, Roberto and Velasco, Andrés, Financial Frictions and Unconventional Monetary Policy in Emerging Economies (February 2016). NBER Working Paper No. w21955, Available at SSRN: https://ssrn.com/abstract=2729056

Roberto Chang (Contact Author)

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

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Andrés Velasco

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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