Stabilization policy in a two country model and the role of financial frictions

This paper studies the optimal choice of exchange rate regimes between two large currency areas. It provides a positive and normative analysis of alternative monetary policy rules in a model with sticky prices, monopolistic competition, and frictions in the processes of capital accumulation and acquisition of external finance. The stabilization and welfare analysis provides a sound result on the desirability of monetary policy and exchange rate flexibility as business cycle smoothing devices. Given the presence of financial frictions the paper gives a richer explanation of the mechanism behind the stabilization properties of floating exchange rates and explains the difference in sign of the international transmission of shocks compared to the model without capital. In a two country model without capital the pattern of output is mainly determined by the pattern of consumption: any movement in the exchange rate under floating exchange rates causes movements in the price of the international traded bond and in consumption and consequently in output. In the model with capital and financial frictions output mimics the movements in investment: an active monetary authority reacting to exchange rate movements generates perverse movements in the interest rate, destabilizing investment and output. The paper also suggests how monetary policy can improve financial stability, stressing the importance of the interest rate smoothing in tuning movements in investment and output and in reducing the welfare cost of financial frictions mostly under fixed exchange rates. JEL Classification: E3, E42, E44, E52, F41