Monetary Policy in a World with Different Financial Systems
51 Pages Posted: 17 May 2003
Date Written: October 2002
Major currency areas are characterized by important differences in financial structure that are clear in microeconomic data. Surprisingly, this fact is seldom discussed in the analysis of the international transmission of shocks. This paper attempts to fill this gap. First, I show some stylized facts about financial differences and cyclical correlations. Second, using a two-country, calibrated to US and euro area data, I analyze the international transmission of shocks with different degrees of financial fragility in the two economies. I find, first, that financial diversity accounts for heterogenous business cycle fluctuations. Differential responses occur with independent monetary policies even with low degrees of economic and financial openness. Credible pegs help to increase the synchronization of cycles. Secondly, differences in persistence of the interest rates help to explain high persistence in the real exchange rate. Finally, weak financial systems can result in large welfare losses under symmetric and correlated shock.
Keywords: Financial diversity, monetary regimes, differential transmission mechanism, financial stability, welfare losses
JEL Classification: E3, E42, E44, E52, F41
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