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 monetary policy rules
that respond to domestic/external financial variables alongside inflation and output. The
Ramsey-optimal policy rule is used as a benchmark. The results suggest that such rules
feature direct and non-negligible responses to the real exchange rate, asset prices and
lending spreads. Furthermore, interest rate policy takes a stronger anti-inflationary stance
when financial stability considerations are addressed by the monetary policy. We find that
a countercyclical reserve requirement rule which responds to fluctuations in credit spreads
and is optimized jointly with a conventional interest rate rule dominates augmented Taylor
rules under country risk premium shocks.