Financial frictions and optimal stabilization policy in a monetary union |
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Affiliation: | 1. Gebze Technical University, Department of Economics, P.K.:141, 41400 Gebze, Kocaeli, Turkey;2. Sabanci University, Faculty of Arts and Social Sciences, Orhanli/Tuzla, 34956 Istanbul, Turkey;1. European Stability Mechanism, 6a Circuit de la Foire Internationale, L-1347 Luxembourg;2. International Labour Organisation, 4 Route des Morillons, Genève 22 CH-1211, Switzerland;1. Seattle University, Department of Economics, Albers School of Business and Economics, Pigott Building 316B, Seattle, WA 98122, USA;2. University of Washington, Department of Economics, Savery Hall 343, Box 353330, Seattle, WA 98195, USA |
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Abstract: | Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem – the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies – does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household. |
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Keywords: | Cost channel Financial frictions Optimal policy Monetary policy Fiscal policy Monetary union |
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