Arnoldshain Seminar XII
A Model about the Interaction of the Monetary
Policy in an Advanced and an Emerging Economy
Neder, Ángel Enrique
Brinatti, Agostina María
Almuzara, Martín Ezequiel
FCE-UNC
Argentina
Valencia
September 2014
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Motivation
• Prices and activity stabilization are not enough for preserving the
financial system from fragility.
• Will there be modifications in the practice of monetary policy in
developed and emerging economies, taking into account the
international financial crisis?
• There have been several works dealing with the behavior of CB in
advanced economies, but most cases were always aimed at
determining the actions of monetary policy only in those economies.
• A model for both types of economies is proposed trying to shed
light on the important role of their interactions, and considering that
intermediation is subject to imperfect competition and financial
frictions, creating an additional transmission channel for monetary
policy.
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The Model
• DSGE
• Two open economies (advanced and emerging)
• Sectors in each economy:
• Households
• Firms
• Banks
• Government (fiscal and monetary authority)
• Assumptions:
•Demands for domestic currency, deposits in domestic currency
(in both economies), and foreign currency (in the case of the
emerging economy)  MIU framework.
• Calvo pricing protocol  Phillips Curve for domestic inflation
• Financial intermediation is subject to imperfect competition
and financial frictions.
• CB sets domestic interest rates according to an “expanded”
Taylor Rule.
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The Model (end)
• Goods, services and assets:
• Consumption and investment goods
• Productive services of capital and labor.
• Deposits (issued by banks) and bonds (issued by government at the
advanced economy)  means of saving.
• Loans and other forms of credit (interbank lending and discount window
facilities)
• Currency (including as foreign currency that issued by the advanced
economy and demanded by the emerging one conform a rudiment of a
foreign exchange market in the emerging economy)
•Distinction between economies:
• Location of financial frictions
• In the advanced economy  imperfections in the domestic
credit market
• In the emerging economy  frictions in the foreign exchange
market
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Households
• Identical at the two economies, except for the EE hoards foreign
currency.
• Full integration of goods market is assumed. Households
consumption is modelled as a Dixit-Stiglitz composite.
• Households optimize their consumption subject to a budget
constraint.
• Goods market open to international trade without barriers  law of
one price  nominal exchange rate.
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Households (end)
Optimization process in the EE
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Firms
Specification of firms are essentially the same for both the
emerging and the advanced economy, except for firms at the
advanced economy are exposed to credit risk.
Three type of Firms:
• Capital good producers: who combine depreciated capital (bought to
entrepreneurs) and investment goods (bought to retailers) to produce new
capital and sell them to entrepreneurs.
• Entrepreneurs are wholesalers who take bank credit to finance the
purchase of capital goods and also demand labor services to produce goods
which are demanded by retailers.
• Retailers: who sell consumption goods to households and investment goods
to capital good producers. They costless differentiate goods and set prices
according to a Calvo protocol.
Every market but investment and consumption good markets are
perfectly competitive. That is to say that retailers are the only ones
who sell goods under monopolistic competition forces.
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Firms
For prices, a similar scheme to that used for consumption goods is
used.
Firms optimize their investment subject to a given level of expenditure
in capital goods, determining a capital price index, which takes into
account the expenditure in domestic and imported capital goods.
Capital good markets open to international trade without barriers 
law of one price  nominal exchange rate.
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Firms: Riskyness of Borrowers
•Entrepreneurs in the AE face an idiosycratic shock .
• A variable
is defined as a cutoff value: entrepreneurs who receive
any value lower than the cutoff are unable to repay their loan in full.
• The cutoff is defined as the value of that satisfies
• The aggregate value of the defaulted loans in nominal terms is
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Banks: Advanced Economy
• Monopolistically competitive banking sector.
• Banks get funds from Households’ deposits and also take credit in a
perfectly competitive interbank market and/or DWF.
• All financial contracts are of one period length with no risk.
Optimization process
To maximize their expected profits, banks set nominal interest rates on
deposits and loans, the quantity of interbank borrowing and DWF.
The net profit function to be maximized is:
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Banks: Advanced Economy
Subject to:
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Banks: Advanced Economy (end)
Euler Conditions:
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Banks: Emerging Economy
• Behaviour similar to Banks in an Advanced Economy with the
difference that the market for deposits is perfectly competitive.
Additionally, they may accumulate government bonds issued both by
the Advanced and by Emerging Economies.
Optimization process
Subject to
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Banks: Emerging Economy (end)
Euler Conditions
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Monetary Policy: Advanced Economy
The CB sets the reference interest rate according to an extended Taylor
Rule.
Since the economy may face a liquidity trap, it´s able to use DWF as an
alternative policy instrument. So, balance sheet is:
DWF rate:
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Benefits transferred:
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Monetary Policy: Emerging Economy
Taylor Rule for deposits interest rate. Doesn´t respond to changes in
the interest rate spread:
CB may incur in sterilized interventions into the foreign exchange
market by varying its stock of foreign bonds in order to compensate
fluctuations in the exchange rate. So, balance sheet is:
Even though space for exchange rate policy is extremely narrow, a
specified rule for int´l reserves constitutes a temptation:
Quasifiscal result
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Governments
In each economy, they play a passive role  Expenditures and Bonds
supply are determined by an autorregressive process, and the budget
constraint determines lump-sum taxes (or transferes) that should be
collected from (or given to) the household sector.
For the Advanced Economy.
Similar considerations apply to EE.
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Equilibrium Conditions
Real Side
Produced goods:
Level of expenditure:
Financial Side
Financial market:
Exchange rate market:
Bonds market:
B of Payments:
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Conclusions and avenues for future research
We built a theoretical model which is a contribution in differentiating
an AE and an EE and their interaction in monetary policy.
Main features of EE:
1. Existence of a hoarding demand for foreign currency.
2. CB intervenes in the exchange rate market with the aim of
moderating the exchange rate volatility.
Main feature of AE:
1. CB provides liquidity aid to any fundamentally sound bank.
2. Existence of risky firms.
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Conclusions and avenues for future research
More work to be done:
1. The incorporation of unconventional monetary policy in the AE
which generates spillovers effects on the EE that forces its CB to
take decisions that would not be taken in the absence of those
effects.
2. Enriching the monetary policy instruments that CB are able to use.
For instance, “microprudential tools”.
3. Considering the existence of monetary policy cooperation.
4. Keep calm and carry on.
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Arnoldshain Seminar XII
A Model about the Interaction of the Monetary
Policy in an Advanced and an Emerging Economy
THANK YOU VERY MUCH!
Neder, Ángel Enrique
Brinatti, Agostina María
Almuzara, Martín Ezequiel
FCE-UNC
Argentina
FCE-UNC
21/21
Neder-Brinatti-Almuzara (2014)