Optimal Monetary Policy in a Currency Union with Interest Rate Spreads

Posted: 9 Jul 2021

See all articles by Saroj Bhattarai

Saroj Bhattarai

University of Texas at Austin - Department of Economics

Jae Won Lee

affiliation not provided to SSRN

Woong Yong Park

affiliation not provided to SSRN

Date Written: 2013

Abstract

We introduce ?financial imperfections? - asymmetric net wealth positions, incomplete risksharing, and interest rate spread 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 spreadadjusted Taylor rule as it helps the real interest rate track the efficient rate of interest.

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 (2013). Globalization and Monetary Policy Institute Working Paper No. 150, Available at SSRN: https://ssrn.com/abstract=3878628

Saroj Bhattarai (Contact Author)

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

Jae Won Lee

affiliation not provided to SSRN

No Address Available

Woong Yong Park

affiliation not provided to SSRN

No Address Available

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