Financial and Price Stability in Emerging Markets: The Role of the Interest Rate

79 Pages Posted: 15 May 2018

See all articles by Lorenzo Menna

Lorenzo Menna

Università degli Studi di Milano-Bicocca - Department of Economics, Management and Statistics (DEMS); Università degli Studi di Milano-Bicocca - Center for European Studies (CefES)

Martín Tobal

Banco de Mexico

Date Written: May 4, 2018

Abstract

The Global Financial Crisis opened a heated debate on whether inflation target regimes must be relaxed and allow for monetary policy to address financial stability concerns. Nonetheless, this debate has focused on the ability of the interest rate to "lean against the wind" and, more generally, on the accumulation of systemic risk arising from the macro-financial challenges faced by advanced economies. This paper extends the debate to emerging markets by developing micro-foundations that allow extending a simplified version of the New-Keynesian credit augmented model of Curdia and Woodford (2016) to a small-open economy scenario, and by subsequently using the same empirical strategy as Ajello et al. (2015) to calibrate the model for Mexico. The results suggest that openness in the capital account, and in particular a strong dependence of domestic financial conditions on capital flows, diminishes the effectiveness of monetary policy to lean against the wind. Indeed, in the open-economy with endogenous financial crises, the optimal policy rate is even below the level that would prevail in the absence of endogenous financial crisis and systemic risk.

Note: Paper produced as part of the BIS Consultative Council for the Americas (CCA) research conference on "Low interest rates, monetary policy and international spillovers" hosted by the Federal Reserve Board, Washington DC, 25–26 May.

Keywords: leaning against the wind, global financial cycle, monetary policy, financial stability

JEL Classification: E52, F32

Suggested Citation

Menna, Lorenzo and Tobal, Martín, Financial and Price Stability in Emerging Markets: The Role of the Interest Rate (May 4, 2018). BIS Working Paper No. 717, Available at SSRN: https://ssrn.com/abstract=3174051

Lorenzo Menna (Contact Author)

Università degli Studi di Milano-Bicocca - Department of Economics, Management and Statistics (DEMS) ( email )

Piazza dell'Ateneo Nuovo, 1
Milan, 20126
Italy

Università degli Studi di Milano-Bicocca - Center for European Studies (CefES)

U6 Building
Viale Piero e Alberto Pirelli, 22
Milano, 20126
Italy

Martín Tobal

Banco de Mexico ( email )

Ave Cinco de Mayo 1
Col. Centro
Mexico City, Mexico DF 06059
Mexico

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