Monetary Rules in Emerging Economies with Financial Market Imperfections

Nicoletta Batini, Paul Levine () and Joseph Pearlman

No 807, School of Economics Discussion Papers from School of Economics, University of Surrey

Abstract: We build a two-bloc emerging market - rest of the world model. The emerging market bloc incorporates partial transactions and liability dollarization, as well as financial frictions including a ‘financial accelerator’, where capital financing is partly or totally in foreign currency as in Gertler et al. (2003) and Gilchrist (2003)). Simulations of the model under various ‘operational’ monetary policy rules derived assuming that the central bank maximizes households’ utility point to important results. First, we reaffirm the finding in the literature that financial frictions, especially when coupled with liability dollarization, severely increase the costs of a fixed exchange rate regime. By contrast, transactions dollarization has only a small impact on the choice of the monetary regime. Second, central banks in emerging economies with these frictions should not explicitly target the exchange rate; nor should they implicitly do so by choosing a CPI rather than domestic price inflation target. Third, with dollarization and frictions, the zero lower bound constraint on the nominal interest rate makes simple Taylor-type rules perform much worse in terms of stabilization performance than fully optimal monetary policy.

Keywords: monetary policy; emerging economies; dollarization; financial accelerator (search for similar items in EconPapers)
JEL-codes: E37 E52 E58 (search for similar items in EconPapers)
Pages: 66 pages
Date: 2007-10
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (44)

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Chapter: Monetary Rules in Emerging Economies with Financial Market Imperfections (2007)
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