Robust Monetary Policy Frameworks for Emerging Markets

The global financial present crisis has highlighted the need for analytical frameworks that adequately model the interactions between the financial system and macroeconomic policy frameworks. In particular, the relationship between the financial sector and monetary policy has become a prominent aspect of recent policy discussions in both advanced and emerging market economies. Getting policy frameworks right has important implications for low- and middle-income economies, both in terms of maintaining high growth and reducing macroeconomic volatility. Developing economies are grappling with trying to understand the right lessons to be learnt from the financial crisis in terms of how to improve policy frameworks to reduce the spillover effects of external shocks and reduce overall vulnerability. The financial crisis highlights the need for a robust analytical framework that takes into account the interactions between the financial and the real sector in order to serve as the underpinning for policy frameworks that foster macroeconomic and financial stability. Monetary policy is typically the first line of defence against external as well as internal shocks. However, the present crisis has raised several new challenges to the conduct of monetary policy in the face of growing macro-financial linkages. It is imperative to develop a framework that can shed light on these linkages and to then use that framework to evaluate various possible strategies. Emerging market economies still tend to have bank-dominated financial systems although many of them are fast developing a broader set of financial markets. In these economies, there are a number of financial frictions that deter the effective functioning of the monetary transmission mechanism. Analytical work that incorporates the banking sector into models of the monetary policy framework is needed to guide these highly topical policy debates. Moreover, for these models to be applicable to emerging market economies, it will be important to model financial market imperfections, which are an endemic feature of these economies (some of these frictions apply to advanced economies as well although to a lesser degree, so the modeling framework may ultimately have broader applicability). Indeed, while there is much discussion in policy circles about macro-financial linkages, there is little formal analytical work on this topic. This research program will focus on developing a dynamic stochastic general equilibrium (DSGE) model with macro-financial linkages and an active banking sector. Our research will attempt to address the following questions: (i) How does the presence of a bank-dominated financial system and various financial frictions affect the monetary transmission mechanism? (ii) What is the role of the banking sector in propagating different types of shocks? (iii) What are the channels through which shocks originating in the credit market are transmitted to the real economy? and (iv) How do non-traditional monetary policy tools affect the transmission mechanism? In a nutshell, the objective of this research is to introduce finance into a monetary policy model in a manner that has relevance for emerging market economies. Clarifying the channels and implications of the interactions between the banking sector and monetary policy in the presence of financial frictions has important implications for growth and stability in low-income and middle-income economies. This project has broad relevance for low-income economies as well as major emerging market economies such as China and India.

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