Optimal Monetary Policy in a Currency Union With Interest Rate Spreads - Dallas Fed

We introduce “financial imperfections” asymmetric net wealth positions, incomplete risksharing, and interest rate spread across member countries in a prototypical two-country currency union model and study implications for monetary policy transmission mechanism and optimal policy. In addition to, and independent from, the standard transmission mechanism associated with nominal rigidities, financial imperfections introduce a wealth redistribution role for monetary policy. Moreover, the two mechanisms reinforce each other and amplify the effects of monetary policy. On the normative side, financial imperfections, via interactions with nominal rigidities, generate two novel policy trade-offs. First, the central bank needs to pay attention to distributional efficiency in addition to macroeconomic (and price level) stability, which implies that a strict inflation targeting policy of setting union-wide inflation to zero is never optimal. Second, the interactions lead to a trade-off in stabilizing relative consumption versus the relative price gap (the deviation of relative prices from their efficient level) across countries, which implies that the central bank allows for less flexibility in relative prices. Finally, we consider how the central bank should respond to a financial shock that causes an increase in the interest rate spread. Under optimal policy, the central bank strongly decreases the deposit rate, which reduces aggregate and distributional inefficiencies by mitigating the drop in output and inflation and the rise in relative consumption and prices. Such a policy response can be well approximated by a spreadadjusted Taylor rule as it helps the real interest rate track the efficient rate of interest. JEL codes: E31, E51, E52, E61, F33, F41 * Saroj Bhattarai,, Pennsylvania State University, Department of Economics, 615 Kern Building, University Park, PA 16802. 814-863-3794. [email protected]. Jae Won Lee, Department of Economics, Rutgers University, 75 Hamilton Street, NJ Hall, New Brunswick, NJ 08901. 848-932-8643. [email protected]. Woong Yong Park, School of Economics and Finance, Room 1007, 10/F, K. K. Leung Building, The University of Hong Kong, Pokfulam Road, Hong Kong. [email protected]. We thank Pierpaolo Benigno, Russ Cooper, Huw Dixon, Robert Kollmann, Neil Wallace, Raf Wouters, Simon Wren-Lewis, seminar participants at University of Hong Kong, University of Exeter, Cardiff University, European Commission, and National Bank of Belgium, and conference participants at the Cornell-Penn State Macro Workshop, the Birmingham Conference in Macroeconomics and Econometrics, the 2013 ERIC International Conference, and the KIF-KAEA-KAFA Joint Conference for valuable comments and suggestions. The views in this paper are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.