Monetary policy and financial shocks in an empirical small open-economy DSGE model

In the aftermath of the global financial crisis in 2008, central banks across the globe reduced their policy rates by unprecedented margins. At the same time, commercial banks were increasing their lending rates in order to protect their crisis-induced fragile balance sheets. To a large extent, these opposing reactions reduced the efficacy of monetary policy in accommodating the substantial decline in aggregate demand seen at the time. In this paper, a standard small open economy New Keynesian DSGE model of the South African economy is extended to incorporate lending rates of commercial banks which deviate from the policy rate, especially in times of financial stress. Within the context of this structural model, the optimal reaction of the SARB to these lending rate deviations – or credit spreads – is analysed. JEL Classification: E44; E52.