External Shocks, Banks, and Optimal Monetary Policy: A Recipe for Emerging Market Central Banks

Abstract

We document that the 2007-09 global financial crisis exposed emerging market economies to an adverse feedback loop of capital outflows, depreciating exchange rates, deteriorating balance sheets, rising credit spreads, and falling real economic activity. We account for these empirical findings by building a New Keynesian DSGE model of a small open economy with a banking sector that has access to both domestic and foreign funding. Using the calibrated model, we investigate optimal, simple, and implementable interest rate rules that respond to domestic/external financial variables alongside inflation and output. The Ramsey-optimal policy is used as a benchmark. We find that optimized interest rate rules respond to the real exchange rate, asset prices, and lending spreads. Furthermore, augmented interest rate policy usually takes a stronger anti-inflationary stance when monetary policy maintains financial stability. A jointly optimized mix of reserve requirements that smooth credit spreads and a standard Taylor-type interest rate rule dominates augmented interest rate rules under country risk premium shocks.