External shocks, banks and optimal monetary policy in an open economy

BIS Working Papers No 528
November 2015

We document empirically that the 2007-09 Global Financial Crisis exposed emerging market economies (EMEs) to an adverse feedback loop of capital outflows, depreciating exchange rates, deteriorating balance sheets, rising credit spreads and falling real economic activity. In order to account for these empirical findings, we build a New-Keynesian DSGE model of a small open economy with a banking sector that has access to both domestic and foreign funding. Using the calibrated model, we investigate optimal, simple and operational monetary policy rules that respond to domestic/external financial variables alongside inflation and output. The Ramsey-optimal policy rule is used as a benchmark. The results suggest that such an optimal policy rule features direct and non-negligible responses to lending spreads over the cost of foreign debt, the real exchange rate and the US policy rate, together with a mild anti-inflationary policy stance in response to domestic and external shocks. Optimal policy faces trade-offs in smoothing inefficient fluctuations in the intratemporal and intertemporal wedges driven by inflation, credit spreads and the real exchange rate. In response to productivity and external shocks, a countercyclical reserve requirement (RR) rule used in coordination with a conventional interest rate rule attains welfare levels comparable to those implied by spread- and real exchange rate-augmented rules.

JEL classification: E44, G21, G28

Keywords: Optimal monetary policy, banks, credit frictions, external shocks, foreign debt