Financial intermediation and monetary policy in a small open economy

Abstract

This paper analyses the role of a costly financial system in the transmission of monetary policy.The new-keynesian model for a small open economy is extended with a simple financial system based in Hamann and Oviedo (2006).The presence of the financial intermediation naturally allows the introduction of standard policy instruments: the repo interest rate and the compulsory requirement of reserves.The model is calibrated to match key steady-state ratios of Colombia and is used to evaluate the alternative policy instruments.The financial system plays an important role in the transmission mechanism of the monetary policy, and determines the final effects on aggregated demand and inflation rates of exogenous modifications of the policy instruments.The monetary policy conducted through the repo interest rate has the standard effects predicted by the new-keynesian framework.But changes in the compulsory reserve requirement rate may generate, under different scenarios, totally different reactions on economic activity, and little quantitative effects on inflation rates and aggregate demand.Therefore this last policy instrument appears to be uneffective and unreliable.

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