Financial Frictions and Optimal Monetary Policy in an Open Economy

by Marcin Kolasa^a and Giovanni Lombardo^b

Abstract

We study welfare-based monetary policy in a two-country DSGE model characterized by financial frictions. We compare the cooperative Ramsey monetary policy with standard policy benchmarks as well as with the optimal Ramsey policy in a currency area. Our main results are the following. First, strict PPI targeting becomes excessively procyclical in response to productivity shocks in the presence of financial frictions. Second, foreign-currency debt denomination affects the optimal monetary policy and has important implications for exchange rate regimes. Third, we find that central banks should allow for deviations from price stability to offset the effects of balance sheet shocks. Fourth, 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. We show that the twocountry perspective offers new insights on the trade-offs faced by the monetary authority. For example, exchange rate adjustments tend to introduce a wedge between the external cost of finance across countries and, hence, they make the cooperative goal of return equalization a more difficult task.

JEL Codes: E52, E61, E44, F36, F41.

 
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