Should monetary policy lean against the wind in a small-open economy? Revisiting the Tinbergen rule

Abstract

While conventional monetary policy maintains its role in counteracting inflation, there are doubts that it is sufficient to guard against the risks of financial instability. It has been debated whether monetary policy should lean against the wind, i.e., if central banks should also respond to the build-up of financial imbalances, such as those associated with unsustainable credit expansion. In the spirit of the Tinbergen rule, some authors have claimed that monetary policy is ineffective in achieving price and financial stability simultaneously. However, others have argued that monetary policy could play a role in taming the credit cycle without compromising its effectiveness to control inflation efficiently. Until now, this analysis has been mostly carried out in a closed-economy setting. I contribute to the debate by showing that targeting the two policy objectives with a single instrument is more costly for a small-open economy than for a closed one. To this end, I develop a small-open economy DSGE model with the Bernanke-Gertler-Gilchrist financial accelerator that features financial frictions and monopolistic competition in goods markets. I then estimate this model for Mexico to explore the policy regimes yielding the lowest welfare cost. My main finding is that the Tinbergen rule is alive and well: Leaning against the wind or augmenting the Taylor rule with an argument on credit growth is not an optimal policy response; instead, the optimal policy mix consists of using two separate tools that focus each on price and financial stability. At the same time, these instruments complement each other to stabilize the economy under financial shocks. Nevertheless, macroprudential measures may not be as useful in helping economic stability under different shocks, particularly when a productivity shock hits the economy. In addition, my model is useful to gauge macroprudential measures effectiveness when discriminating against foreign liabilities. In this regard, I find that macroprudential measures that consider both internal and external debt are more effective than capital controls.

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