Household and firm leverage, capital flows and monetary policy in a small open economy

This paper presents a framework to analyze the interplay between ?financial frictions at the household and fi?rm level, liability dollarization and monetary policy in a small open economy subject to productivity and capital infl?ow shocks. Optimized monetary policy rules are calculated under several speci?cations (infl?ation targeting, exchange rate targeting, fi?xed exchange rate, credit growth targeting) and for two central bank?s objectives (macreconomic stability and macroeconomic plus fi?nancial stability). I ?find that, fi?rst, adding ?financial stability to the central bank?s objectives results in more inertial monetary policy rules. Second, the optimized Taylor rules under the ?financial stability objective achieve a lower volatility of infl?ation and of credit growth at the same time. However, this comes at the expense of a higher standard deviation of production. Third, when ?financial stability is included among the central bank?s objectives, engaging in exchange rate smoothing delivers the smallest value of the central bank?s loss function, mainly arising through a much reduced volatility of the credit aggregate. In the considered economy, credit growth targeting is suboptimal because of the effect of stronger interest rate increase on currency ?uctuations, which reinforce the ?financial accelerator. Finally, for the considered shocks, the extent of co-movement of fi?nancial variables pertaining to entrepreneurs and homeowners crucially depends on the degree of exchange rate fl?exibility.