Optimal Monetary Policy in a Currency Union with Interest Rate Spreads

Abstract

We study optimal monetary policy in a two-country currency union model with nominal and financial frictions. In addition to, and independent from, the standard transmission mechanism associated with sticky prices, financial frictions combined with asymmetric asset positions introduce a wealth redistribution role for monetary policy in our model. Financial frictions also lead to a spread between the deposit and borrowing interest rate and variation in the spread affects both aggregate variables, by affecting total spending, and relative (cross-country) variables, by redistributing wealth across countries. Moreover, the interactions between nominal and financial frictions amplify the effects of monetary policy; imply that a strict inflation targeting policy of setting union-wide inflation to zero is never optimal and that optimal policy never attains efficiency; and lead to a novel policy trade-o¤ for the central bank in stabilizing relative consumption versus the relative price gap (the deviation of relative prices from their efficient level). Finally, under optimal monetary policy, in response to an aggregate purely financial shock that causes an increase in the interest rate spread, the central bank strongly decreases the deposit rate, which reduces aggregate and distributional inefficiencies by mitigating the drop in output and inflation and the rise in relative consumption and prices. We also show that while a traditional Taylor rule approximates optimal policy imperfectly, especially in response to the financial shock, a spread-adjusted Taylor rule performs better as it helps the real interest rate track the efficient rate of interest.