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Financial frictions and unconventional monetary policy in emerging economies

Chang, Roberto and Velasco, Andres ORCID: 0000-0003-0441-5062 (2017) Financial frictions and unconventional monetary policy in emerging economies. IMF Economic Review, 65 (1). pp. 154-191. ISSN 2041-4161

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Identification Number: 10.1057/s41308-016-0024-y


We analyze conventional and unconventional monetary policies in a dynamic small open-economy model with financial frictions. In the model, financial intermediaries or banks borrow from the world market and lend to domestic households. Banks can borrow abroad up to a multiple of their equity; in turn, there is a limit to how much bank equity households can hold. The combination of external and domestic frictions results in an economy-wide credit constraint and an endogenous interest rate spread. It also magnifies the amplitude and persistence of aggregate responses to exogenous shocks. In response to external balance shocks, fixed exchange rates are contractionary and flexible exchange rates expansionary (although less so in the presence of currency mismatches); the opposite is true in response to increases in the world interest rate. Unconventional policies, including central bank direct credit, discount lending, and equity injections to banks, have real effects only if financial constraints bind. Because of bank leverage, central bank discount lending and equity injections are more effective than direct credit. Sterilized foreign exchange intervention is equivalent to lending directly to domestic agents. Unconventional policies are feasible only to the extent that the central bank holds a sufficient amount of international reserves.

Item Type: Article
Additional Information: © 2017 Elsevier
Divisions: School of Public Policy
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Subjects: H Social Sciences > HG Finance
Date Deposited: 10 Oct 2019 14:27
Last Modified: 20 Sep 2021 02:13

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