Cross border flows, financial Intermediation and interactions of policy rules in a small open economy model

Ashima Goyal and Akhilesh Verma

Indira Gandhi Institute of Development Research, Mumbai Working Papers from Indira Gandhi Institute of Development Research, Mumbai, India

Abstract: We present a small open economy New Keynesian model with financial intermediation to investigate the interaction between monetary policy and macroprudential regulations. Our model economy attempts to capture the vulnerability of emerging market economies in the face of external and domestic shocks. We build a model that closely captures the dynamics of emerging market economies to show that interest rate policy rules alone may not be an effective instrument to stabilize the economy under negative shocks. Monetary policy implementation through augmented Taylor rule (ATR) is an inadequate tool to absorb negative shocks given its conflict between inflation and exchange rate objectives. We show that the use of macroprudential regulations (MaPs) with simple Taylor rule improves business cycle dynamics relative to ATR under domestic and external shocks. We present two kinds of MaP regulations to show that they effectively mitigate losses during economic downturns and reduce excessive risk-taking behavior during economic booms when used along with a simple monetary policy rule (MP). In addition, we also conduct welfare evaluation that supports complementarity between MP and MaPs under different shocks.

Keywords: DSGE model; cross border flows; monetary policy macroprudential regulation (search for similar items in EconPapers)
JEL-codes: E44 E52 E61 F42 G28 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2020-03
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:ind:igiwpp:2020-008

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