DP4370 A Simple Model of Optimal Monetary Policy with Financial Constraints

Author(s): Michael B Devereux , Doris Poon

Publication Date: April 2004

Keyword(s): monetary policy , collateral constraints , exchange rate

JEL(s): F00 , F40

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4370.asp

Recent experience suggests that the operation of monetary policy in emerging market economies is severely limited by the presence of financial constraints. This is seen in the tendency to follow contractionary monetary policy during crises, and the observation that these countries pursue much more stable exchange rates than do high income advanced economies, despite having a more volatile external environment. This Paper analyses the use of monetary policy in an open economy in which exchange rate sensitive collateral constraints may bind in some states of the world. The appeal of the model is that it allows for a complete analytical description of the effects of collateral constraints, and admits a full characterization of welfare-maximizing monetary policy rules. The model can explain the two empirical features of emerging market monetary policy described above – in particular, that optimal monetary policy may be pro-cyclical under binding collateral constraints, and an economy with large external shocks may favour a fixed exchange rate, even though flexible exchange rates are preferred when external shocks are smaller.