Financial Frictions and Unconventional Monetary Policy in Emerging Economies, Roberto Chang (Rutgers University and NBER), Andrés Velasco (Columbia University and NBER), Paper presented at the 16th Jacques Polak Annual Research Conference, Washington, DC─November 5–6, 2015

This paper discusses 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. The external debt of banks is limited by a multiple of their equity; in turn, households hold equity in banks subject to a limit, reflecting domestic frictions. As a result, there is an economy wide credit constraint determined by a combination of external and domestic frictions, and an endogenous interest rate spread arises. Financial frictions are shown to add amplification and persistence to exogenous shocks. Fixed exchange rates are contractionary and flexible exchange rates are expansionary (although less so in the presence of currency mismatches). 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 one of the preceding operations. Unconventional policies are feasible only to the extent that the central bank holds a sufficient amount of international reserves.