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Open-economy macroeconomics with financial frictions: A simple model with flexible exchange rates

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  • Agénor, Pierre-Richard

Abstract

A simple macroeconomic model with banking, financial frictions, and flexible exchange rates is used to study the performance of fiscal, monetary and macroprudential policy combinations in response to domestic and external shocks. After characterizing the transmission process of each instrument, a diagrammatic analysis of how these policies should be used, either individually or jointly, to promote economic and financial stability, is provided. The analysis shows that whether a policy should be assigned to internal or external balance, and whether it should be contractionary or expansionary, depends not only on the nature of the shocks impinging on the economy but also on the range of tools available to policymakers and the strength of financial frictions. In particular, in response to an external financial shock, monetary policy should be assigned to external balance, and fiscal policy or macroprudential regulation to internal balance. These two policies are substitutes when used in combination with monetary policy.

Suggested Citation

  • Agénor, Pierre-Richard, 2024. "Open-economy macroeconomics with financial frictions: A simple model with flexible exchange rates," Journal of Financial Stability, Elsevier, vol. 73(C).
    • Handle: RePEc:eee:finsta:v:73:y:2024:i:c:s1572308924000780
    DOI: 10.1016/j.jfs.2024.101293
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    More about this item

    Keywords

    Financial frictions; Open-economy macroeconomics; Policy combinations; Macroeconomic and financial stability;
    All these keywords.

    JEL classification:

    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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