Household and firm leverage, capital flows and monetary policy in a small open economy
Faculty of Applied Economics
Antwerp :Universiteit Antwerpen, Faculty of Applied Economics, 2013
Research paper / University of Antwerp, Faculty of Applied Economics ; 2013:014
University of Antwerp
This paper presents a framework to analyze the interplay between …nancial frictions at the household and …rm level, liability dollarization and monetary policy in a small open economy subject to productivity and capital in‡ow shocks. Optimized monetary policy rules are calculated under several speci…cations (in‡ation targeting, exchange rate targeting, …xed exchange rate, credit growth targeting) and for two central bank’s objectives (macreconomic stability and macroeconomic plus …nancial stability). I …nd that, …rst, adding …nancial stability to the central bank’s objectives results in more inertial monetary policy rules. Second, the optimized Taylor rules under the …nancial stability objective achieve a lower volatility of in‡ation and of credit growth at the same time. However, this comes at the expense of a higher standard deviation of produc- tion. Third, when …nancial stability is included among the central bank’s objectives, engaging in exchange rate smoothing delivers the smallest value of the central bank’s loss function, mainly arising through a much reduced volatility of the credit aggregate. In the considered economy, credit growth targeting is suboptimal because of the e¤ect of stronger interest rate increase on currency ‡uctuations, which reinforce the …nancial accelerator. Finally, for the considered shocks, the extent of co-movement of …nancial variables pertaining to entrepreneurs and homeowners crucially depends on the degree of exchange rate ‡exibility.