Monetary policy in a currency union with heterogeneous limited asset markets participation

Working paper

This paper examines monetary policy in a currency union whose member countries exhibit heterogneous rates of limited asset markets participation (LAMP). As a result risk sharing among member countries is imperfect and the monetary transmission mechanism can differ across countries. In the limit the elasticity of output to the union-wide nominal interest rate can be of opposite sign in different countries. I develop a tractable model in which the dispersion of asset markets participation (AMP) becomes a key parameter. While monetary policy can guarantee determinacy by following an active or passive rule depending on the sign of the interest-elasticity of output, ignoring dispersion can lead to incorrect computation of the sign and the size of the latter. Taking the heterogeneity into account is thus central for sound policy. Furthermore, due to the failure of risk sharing, determinacy for union-aggregates does not guarantee determinacy in every member country. However, the more open a country is in trade terms, the greater the rate of LAMP for which the country still displays equilibrium determinacy. For complete openness, determinacy is guaranteed. This underlines the importance of risk sharing and trade integration for the functioning of a currency union. Considering the optimal union-wide targeting rule, a higher mean and dispersion of LAMP increase the desired inflation volatility and decrease the desired output volatility. The implied optimal Taylor rule shows that subject to the Taylor principle, the higher are mean and dispersion of LAMP, the softer should be the response of the nominal interest rate to expected inflation.

Authors: Eser, F

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2009-11-01
• Paper number: 2009-W16
• Keywords: sticky prices; (optimal) monetary policy; real (in)determinacy; participation; monetary union; limited asset markets; heterogeneity