Research InstituteDiscussion Paper Series№01
Title：Monetary policy in a two-country modelwith financial market imperfections

Daisuke Ida／井田大輔
ida-dai@andrew.ac.jp

2015 年 10 月

http://www.andrew.ac.jp/soken/

Monetary policy in a two-country modelwith financial market imperfections

Daisuke Ida*

This draft: October 21, 2015

Abstract
This paper examines whether financial market imperfections are important in a two-country
economy with nominal price rigidities. The implication obtained in a standard open economy model
is applicable to our model in the case of no financial friction in the foreign country. However, aforeign financial friction changes the prescription for monetary policy derived in a standard
two-country model. The transmission mechanism of foreign structural shocks differs when a foreign
financial friction exists. In such a case, even if the home country does not face a severe financial
friction, a severe financial friction in the foreign country amplifies the impact of foreign shocks on
the macro variables of home country. In addition, this paper finds the effectiveness of an output gap
growth rule in a two-country economy with financial market imperfections. In sum, this paper
suggests that financial market imperfections play a significant role in a two-country model.

Keywords: Financial market imperfections; Cost channel; Monetary policy rules; Two-country model
JEL classification: E52; E58; F41*Department of Economics, Momoyama Gakuin University, 1-1, Manabino, Izumi, Ozaka 599-8251, Japan. Tel.:+81-725-54-3131. E-mail: ida-dai@andrew.ac.jp

11. Introduction
It has been argued that the presence of financial market imperfections significantly affects thetransmission mechanism of monetary policy. For instance, Bernanke, Gertler and Gilchrist (1999)
incorporate financial market friction into the standard new Keynesian model and emphasise afinancial accelerator effect, whereby changes of an external financial premium persistently influence
the real economy.1 In addition, financial market imperfections are associated with a cost channel
that generates inflation through an increase in a firm’s working capital after monetary tightening.
Ravenna and Walsh (2006) investigate optimal monetary policy in an economy with a cost channel
and reveal that the presence of a cost channel generates a wedge between stabilising inflation and theoutput gap. Chowdhury, Hoffman and Schabert (2006), Tillmann (2008), and Ida (2014) find that acost channel can help explain inflation dynamics in the developed countries. Recently, Pfajfar andSantoro (2014) reveal that a monetary policy rule might contain the stabilisation of asset pricefluctuations to attain the rational expectations equilibrium in a new Keynesian model in which asevere cost channel is present.
On the other hand, globalisation through international trade and finance has expanded rapidly.
Thus, economic shocks that occur in one country are likely to increasingly affect macroeconomic
variables in other countries as globalisation proceeds. Clarida, Gali and Gertler (2002) develop a
two-country economy model with sticky prices to examine international dimensions of optimalmonetary policy. However, their model abstracts the role of financial market imperfections. We
observe that the financial turmoil that originated in the United States has led to severe economic
stagnation in developed countries. Thus, financial market imperfections play a significant role inlarge countries. This is because financial market imperfections in one country spill-over into othercountries. Accordingly, we require a model that considers the role of financial market imperfections
in a two-country framework. As far as we know, however, very few studies have focused onmonetary policy in an open economy model with financial market imperfections.
This paper examines whether financial market imperfections are important in a two-country
sticky price model. In particular, we focus on the impact of a change in financial market
imperfections in the foreign country on the home country. To do this, we incorporate financial
market imperfections into a two-country sticky price model developed by Clarida, Gali and Gertler(2002).
Moreover, we employ the idea of Chowdhury, Hoffmann and Schabert (2006) to consider therole of financial market imperfections in an open economy. Chowdhury, Hoffmann and Schabert(2006) explore whether the presence of incomplete pass-through between lending and policy rates

1 Based on the framework of Bernanke, Gertler and Gilchrist (1999), Bernanke and Gertler (1999) examine whether

the central bank should respond to asset prices when asset price bubbles are present.

2explains inflation dynamics in developed countries. To drive such a wedge between lending andpolicy rates, they consider the adverse selection problem associated with asymmetric information in
the credit market. However, their model does not provide a micro-foundation for such an incomplete
interest rate pass-through.
In contrast to their model, Kobayashi (2008) and Teranishi (2008) present a micro foundation ofimperfect lending rate pass-through by introducing staggered loan contracts in the canonical new
Keynesian model. Instead of introducing a micro foundation of financial market imperfections, theidea of Chowdhury, Hoffmann and Schabert (2006) is simple and intuitively understandable. A
notable feature of our model is its ability to examine how financial market imperfections amplify thetransmission of structural shocks in a two-country framework. Therefore, this study provides
significant implications for monetary policy analysis in an open economy model with financial
market imperfections.
Is financial instability important in open economies? De Giorgio and Nistico (2007) develop a
two-country sticky price model in which asset prices fluctuate in the foreign country. They show thatthe central bank should follow a monetary policy rule that includes the stabilisation of foreign asset
prices. Fujiwara and Teranishi (2009) construct a two-country model with staggered loan contracts inboth countries. According to their analysis, both domestic and foreign central banks should stabilise
international financial shocks when staggered loan contracts are present in both countries. Hence,both central banks should consider international financial heterogeneity associated with staggeredloan contracts in both countries when implementing optimal monetary policy.2
Ida (2011) also examines how a central bank should conduct its monetary policy when asset
price fluctuations spill-over in both countries and reveals that an instrument rule that responds toboth domestic and foreign asset prices leads to preferable outcomes compared with a simple rule that
only reacts to the inflation rate. However, Ida (2011) does not examine how the degree of financial
market imperfections affects the performance of asset price rules.
These studies stress the importance that the central bank cares about financial instability fromthe perspective of a global economy. It seems, however, that few studies explore the role ofimperfect financial markets in transmitting structural shocks in a two-country economy.
We confirm that the implication obtained in a standard open economy model is applicable toour model in the case of no financial friction in the foreign country. However, a foreign financial
friction changes the implication for monetary policy derived in a canonical two-country model. The
transmission mechanism of foreign structural shocks differs in the case of financial friction in theforeign country. In such a case, even if the home country does not experience a severe financial
friction, a severe financial friction in the foreign country makes the impact of foreign shocks on the2

Fujiwara and Teranishi (2009) investigate the effect of the presence of staggered loan contracts on monetary policy
in a two-country economy with flexible prices.

3

macro variables of the home country large.
This paper also finds the effectiveness of an output gap growth rule in a two-country economy
with financial market imperfections. This rule can achieve the smaller variances of inflation and theoutput gap. In particular, there are gains from employing this rule for a real shock. Intuitively, since achange of the output gap fluctuates the home terms of trade, changing the real exchange rate, a speed
limit rule that smooths a change of the output gap can stabilise the real exchange rate.
On the other hand, an asset price target rule can attain the smallest variance of inflation of allpolicy regimes, whereas it produces the largest variances of the output gap. However, in the case of aforeign loan rate shock, an asset price rule can attain the preferable outcome. Thus, there might begain from employing an asset price rule for a financial shock. Consider the case of an exogenous
loan rate shock as a financial shock. There are two channels whereby a change in the lending rate
fluctuates inflation. First, a change in the loan rate affects the real marginal cost, changing the
inflation rate. Second, share prices cause fluctuations in the inflation rate through a change in
dividends. An asset price rule can completely stabilise the second channel generated by financial
shocks. This is the gain from employing an asset price rule when financial shocks matter.
The remainder of this study is constructed as follows. Section 2 describes our model. Section 3
derives the log-linearised system of the model. Section 4 calibrates the deep parameters. Section 5reports our simulation results. Section 6 briefly concludes the study.

2. ModelWe incorporate a simple financial market friction associated with a cost channel into a
two-country framework developed by Clarida, Gali and Gertler (2002). Consider an economy with
two large symmetric countries: home and foreign. The population sizes for home and foreign are

1   and  , respectively. There are two production sectors in each country. Final goods sectors
are characterized by perfect competition. The firms in intermediate goods sectors face monopolisticcompetition and Calvo (1983) type nominal price rigidity.
In addition, for intermediate firms to pay employee wages, they must borrow funds fromfinancial intermediaries located in the home country. Following Ravenna and Walsh (2006) and
Chowdhury, Hoffmann and Schabert (2006), we introduce the role of financial intermediaries into
the model. Financial intermediaries receive deposits from domestic households and lend the funds todomestic firms. When financial intermediaries lend funds to intermediate goods producers, they
incur a monitoring cost.
Our model assumes that there are complete markets in both countries and that households inboth countries can trade a state-contingent bond domestically and internationally. Moreover, we
assume that only final goods are traded. Finally, unless otherwise noted, analogous equations hold4

for the foreign country.

2.1. Households
The consumption index for the domestic country, C t , is given byCt  (1   )1 / a C H( a,t 1) / a   1 / a C F( a,t1) / aa /( a 1),(1)

where C H ,t denotes the consumption of domestic goods and C F ,t denotes the consumption offoreign goods. The parameter a denotes the elasticity of substitution between domestic and foreign
consumption goods.
First, households consider an intra-temporal cost minimisation problem and derive the demand
function for each good:a PH ,t  Ct ,C H ,t  (1   )
 Pt 

(2)

a PF ,t  Ct ,C F ,t   
P
 t 

(3)

where the price index in the home country is given by

Pt  (1   ) PH1,ta  PF1,ta

1 /(1 a ),(4)

where PH ,t is the price of domestic goods, and PF ,t is the price of foreign goods.
Next, we consider the household’s dynamic optimisation problem. The inter-temporal utility of
an infinitely lived representative household is Ct1j
N t1j ,
U t  Et  



1


1


j 0




j

(5)

where N t is the household’s labour supply. The parameter  denotes the discount factor. In
addition,  and  are positive parameters. The representative household faces the following
budget constraint:

Pt Ct  Pt Qt At  M t 1  Et t ,t 1 Bt 1  Dt  M t  Bt  RtD Dt  Pt At t   t ( B)  Wt Nt  Pt Qt At 1  PtTt ,(6)Dtwhere R denotes the gross nominal interest rate on deposits and Dt is the deposit in financial
intermediaries. Bt is the nominal bond and t ,t 1 is the stochastic discount factor, which denotes
the bond price of in terms of home currency. Wt and t are the nominal wage and the dividend
5

from intermediate goods firms.  t (B) denotes the dividend from financial intermediaries and At 1
denotes shares of stock that sell at price Qt . The equities are owned by the ownership of firms.

M t is the nominal money stock and Tt denotes lump-sum transfers. In addition, therepresentative household faces a cash-in-advance constraint, which is given as follows:

Pt Ct  M t  Dt  Wt N t .

(7)

As in Ravenna and Walsh (2006), Equation (7) states that households enter period t with cash
holdings of M t . Before households enter goods and financial markets, they deposit the fund of Dt
at financial intermediaries. Hence, remaining cash balances of households are subject to a
cash-in-advance constraint (7).
The household maximises its own utility, subject to Eqs. (6) and (7). If the nominal interest rate
is positive, the first-order conditions of this optimisation problem are as follows:P Ct  Et  Rt Ct1 t  ,Pt 1 (8)N t Wt
,

Pt
Ct

(9)

Ct (Qt  t )  Et Ct1 Qt 1 .

(10)Equation (8) represents an Euler equation for consumption. The left-hand side of Eq. (8) is themarginal utility in period t , whereas the right-hand side of Eq. (8) is the discounted marginal utilityof consumption in period t  1 . The Euler equation requires that in equilibrium, the marginal utilityof consumption inter-temporally equalises through the adjustment of the real interest rate.3 Equation(9) is the marginal rate of substitution between consumption and household labour supply. Equations(10) represents the dynamics of share prices Qt .
2.2. Firms
There are two production sectors in each country. The first is the final goods sector, which
produces final goods using intermediate goods and is characterised by perfect competition. The
second is the intermediate goods sector in which firms face monopolistic competition and Calvo
pricing. In addition, intermediate goods firms have to borrow funds from financial intermediaries topay employee wages. As in Pfajfar and Santoro (2014), it is also assumed that firms are completely
rationed on the equity market. This assumption enables the model to consider the case wherein firms

3

We checked that in competitive bond and deposit markets, the nominal interest rate on bonds is equal to the deposit
rate through the arbitrage condition between bond and deposit markets.

6borrow funds from financial intermediaries because financial gaps generated by the shortage offirm’s internal funds exist.4 Therefore, in this model, the intermediate firms borrow the funds fromfinancial intermediaries while they also issue their own securities, which are held by domestic
households.

2.2.1. The final goods sector
Each final goods firm employs the following CES technology:
 1

 1
 1

Yt    Yt (i)  di  .
0



(11)

where Yt is aggregate output, Yt (i) denotes demand for intermediate goods produced by firm i .
Also, the parameter  is the elasticity of substitution for individual goods. This parameter satisfies  1.
The demand for intermediate goods is given as PH ,t (i)  Yt ,Yt (i)  P
 H ,t (12)where PH ,t (i) is the price for intermediate goods produced by firm i and the price index in thiscase is given by1

11
PH ,t    PH ,t (i )1 di  .
 0


(13)

2.2.2. Intermediate goods sector
The intermediate goods sector is characterised by monopolistic competition, and each firm
produces a differentiated intermediate good. Firm i ’s production function is given by

Yt (i)  Z t N t (i) ,(14)

where Z t denotes an aggregate productivity disturbance, which follows an AR (1) process given
by log( Z t )   z log( Z t 1 )   tz with 0   z  1 .  tz is an i.i.d shock with constant variance z2 .

Following Calvo (1983), we assume that price rigidity exists in the intermediate goods sector.
Thus, a fraction 1   of all firms adjusts their prices while the remaining fraction of firms  do
4

See Pfajfar and Santoro (2014) for a detailed discussion of this problem.

7

not. When revising their prices, these firms take into account uncertainty concerning when they will
be able to adjust prices next. As such, the intermediate firm's optimisation problem is given by P opt 1
 PHopt,t  H ,t  t j  Yt  j ,Et    t ,t  j 




P
P

j 0
 H ,t  j   H ,t  j 


j

(15)

where  t ,t  j is again the stochastic discount factor, which is given by  j (Ct  j / Ct )  . Also  tdenotes the real marginal cost and PHopt
is the optimal price index in period t .
,t
The first order condition of this optimisation problem is as follows: Ct  j Et  ( ) j 0
 Ct 
j PHopt,t PHopt,t 






t  j 
P



1
P
H
,
t

j
H
,
t

j






1
Yt  j  0 .
PHopt,t(16)

We assume that in order for intermediate firms to pay employee wages, they have to borrow thefunds Wt N t from domestic financial intermediaries at the gross lending rate RtL . Intermediatefirms face the following cost minimisation problem:

RtL

Wt
N t   t ( Z t N t  Yt ) .
PH ,t

(17)

Cost minimisation leads tot 

1 Wt LRt .
Z t PH ,t(18)

In contrast to the standard new Keynesian analysis, as intermediate firms have to borrow funds fromfinancial intermediaries under the assumption of the cost channel, their real marginal costs also
depend on the lending rate. When the central bank raises the nominal interest rate, intermediate firmi 's working capital increases because monetary tightening induces an increase in the lending rate.
This indicates that a monetary tightening policy directly increases the real marginal cost.
Finally, as employed in the framework of Pfajfar and Santoro (2014), we assume that firms
fully transfer their profits through dividends to the shareholders. In this case, the dividends to theshareholders are given as follows:t  Yt  RtL

Wt
Nt  (1  t )Yt .
PH ,t

(19)

In contrast to the case of no cost channel, the lending rate affects the dividends to stockholders.
Hence, it follows from Eq. (10) that the lending rate influences the dynamics of stock prices.

2.3. Financial intermediaries
Domestic financial intermediaries provide deposit services to domestic households. If a8

domestic household deposits an amount of Dt in period t , it will receive a deposit of Rt Dt atthe end of the period. In turn, the financial intermediaries receive deposits from domestic households
and lend the funds to domestic firms.
When financial intermediaries lend funds to intermediate goods producers, they incur amonitoring cost,  ( Rt ) . One possible interpretation of the monitoring cost  ( Rt ) is as follows.
The monitoring cost  ( Rt ) could arise due to adverse selection between financial intermediaries
and firms. When the adverse selection problem is present, financial intermediaries incur amonitoring cost during the selection of good borrowers in the credit market. Financial intermediaries
set their loan rates higher than market rates because they face a risk of default by firms. The
borrowers who have the opportunity to invest in good projects cannot negotiate loan contracts withfinancial intermediaries as long as the lending rate is higher than the short-term nominal interest rate.
As a result, there only exist borrowers who have the opportunity to invest in bad projects. In thissituation, the financial intermediaries’ profit decreases as the nominal interest rate increases. Hence,
the monitoring cost function depends on a change in the nominal interest rate. To capture thisargument in the model, following Chowdhury, Hoffmann, and Schabert (2006), we assume that thismonitoring cost is differentiable and satisfies the following properties:  ( Rt )  0 and ( Rt )  0 .
Financial intermediaries face the following profit maximisation problem: t ( B) RtL (1  ( Rt )e t ) Lt  Rt Dt  kLt ,(20)

subject to Lt  Dt , where Lt denotes loans for the firm. The parameter k represents the
management cost, which is constant. Also, we incorporate a financial market shock  t into themodel. We interpret this disturbance as an exogenous risk premium shock. The financial market
disturbance  t follows an AR (1) process given by  t   t 1   t with 0    1 .  t isan i.i.d shock with constant variance  2 . The equilibrium for the lending market is Dt  Wt N td ,where N td denotes the demand for labour.
2.4. Equilibrium
The clearing conditions for the goods market in home and foreign countries are

Yt  CH ,t  CH* ,t ,(21)

Yt*  CF ,t  CF* ,t ,(22)

where asterisks denote foreign variables.
Substituting Equation (2) and the corresponding equation in the foreign country into Equation
9

(21), we obtainYt  (1   )[(1   )  1ta ]a (1a ) Ct   [  (1   )(*t ) a1 ]a (1a ) Ct* ,(23)

where  t  PF ,t / PH ,t denotes the home terms of trade.
The clearing condition of stock market in each country is At  1 . Also, the clearing conditionof international bond market is given as follows:

Bt  Bt*  0 .
Next, we consider a risk sharing condition between countries. The Euler equation for foreign
consumption denominated in domestic currency is given by

 C *   P * e 1tt, Et  t *1 
*
e
Rt*
C
P
 t t 1 t 1 
(24)

where et denotes the nominal exchange rate. Given the assumption that there are state-contingent
bonds that both domestic and foreign households can trade internationally, combining Eq. (24) with
the Euler equation for domestic consumption and using the definition of the real exchange rate

S t  et Pt* / Pt , the real exchange rate becomesC 
St    t*  ,
 Ct 

(25)

where  is a constant term. Equation (25) states that the real exchange rate adjusts the difference
between domestic and foreign consumption.
Finally, the fiscal authority satisfies the following budget constraint:

Pt Tt  M t 1  M t  Bt 1  Rt Bt .

(26)

3. Log-linearisation
This section provides the log-linearisation of the system around the steady state. A
log-linearised variable around the steady state is expressed by Hˆ  log( H / H ) , where Httrepresents a steady-state value.
First, log-linearisation of Equation (23), we obtainYˆt  Cˆ t   [2(1   )a   1 (1  2 )]ˆ t .

(27)

Also, the corresponding equation in the foreign country is given by

10

ˆ .
Yˆt*  Cˆ t*   [2(1   )a   1 (1  2 )]
t(28)

Subtracting Equation (28) from Equation (27), we obtain the following log-linearised relationshipbetween terms of trade and the relative output:

ˆ t  1 (Yˆt  Yˆt* ) ,(29)

where   4 (1   )( a  1)  1 .
Log-linearisation of the Euler equation for consumption is given byCˆ t  Et Cˆ t 1   1[ Rˆ t  Et  t 1 ] ,(30)

where  t  log( Pt / Pt 1 ) denotes consumer price index (CPI) inflation.
To express in terms of log-deviation from their flexible price equilibrium counterparts, we
introduce the following notations:qt  Qˆ t  Qˆ t f , yt  Yˆt  Yˆt f ,  t  ˆ t  ˆ t f ,where the superscript f denotes the log-deviation of the natural level.
The log-linearised Euler equation for stock prices is given as follows:qt  (1   ) t  Et qt 1   ( Rˆ t  Et  t 1 ) ,(31)

The second term on the right hand side indicates that future stock prices affects stock prices inperiod t . The third term of the right hand side of Eq. (31) is the real interest rate. An increase in thereal interest rate decreases stock prices. As we will show, stock prices in the home country areindirectly influenced by the movements in the foreign output gap through the domestic dividends.
Using Equations (27), (28), (29), and the definition of the output gap, the real marginal cost in
an open economy is given as follows:ˆ t  Rˆ tL  (     ) yt   yt* ,(32)

where    1 and   2 (1   )( a  1) .
As shown in Ravenna and Walsh (2006) and Chowdhury, Hoffmann and Schabert (2006), the real
marginal cost depends on the lending rate in an economy with a cost channel. Moreover, the foreign
output gap affects the real marginal cost through the terms of trade and consumption risk sharing inan open economy. For instance, as discussed in Clarida, Gali and Gertler (2002) and Pappa (2004),
there exist externalities associated with an open economy as long as the parameter  a is not unity.
If  a  1 , domestic and foreign goods are substitute in the Pareto-Edgeworth sense. Whenthe parameter  a takes a value above one, domestic inflation increases in response to an increasein the foreign output gap. This is because a positive output gap in the foreign country induces an11increase in the domestic real marginal cost. On the other hand, if  a  1 , two goods arecomplements. In the case where the parameter  a takes a value less than unity, the domestic
inflation rate declines because a positive foreign output gap reduces the domestic marginal cost. As
mentioned earlier, these effects cancel out when the parameter  a takes unity.
A log-linearisation of the dividends from the firms to the stockholders is as follows:ˆ t  Yˆt  (  1)ˆt .
Using the definition of the dividend gap and substituting the real marginal cost into the above
equation, we obtain t  [1  (  1)(     )] yt  (  1) yt*  (  1) Rˆ tL .

(33)

Equation (29) indicates that the lending rate negatively affects stock prices through firm’s dividends
to stockholders in the home country. In contrast to the framework of Pfajfar and Santoro (2014),
there is a spill-over effect of an open economy on firm’s dividends to the domestic stockholders.
This effect is captured by the second term of the right hand side. Thus, it follows from Eq. (33) thatthe foreign output gap influences the domestic dividends through the terms of trade and throughconsumption risk sharing. For instance, the foreign output gap reduces the domestic dividends when
the parameter  a takes a value above unity. The foreign output gap increases the domestic
dividends when the parameter  a takes a value less than unity. These effects disappear when theparameter  a takes unity. Thus, the foreign output gap affects the domestic stock prices throughthe domestic dividends as long as the parameter  a is not unity.
The relationship between the real exchange rate and the terms of trade is given bySˆt  (1  2 )ˆ t .

(34)

Using Equation (29), the real exchange rate can be expressed as follows:(1  2 ) ˆ ˆ *Sˆt (Yt  Yt ) .
(35)

Thus, if foreign output is constant, an increase in output in the home country depreciates the realexchange rate.
Next, the log-linearised lending rate is given as follows:Rˆ tL  (1   R ) Rˆ t   t ,(36)

where  R represents the degree of lending rate pass-through.5 It follows from Eq. (36) that thelending rate deviates from the policy rate as pass-through of the lending rate becomes incomplete:
the higher value of the parameter  R , the more incomplete interest rate pass-through is. As
5

See Chowdhury et al. (2006) for a detailed discussion of Eq. (36).

12indicated in a closed economy model, it is possible that when the economy faces severe financial
market imperfections, monetary tightening easily increases the inflation rate through the supply side
effect of monetary policy. Note that as in Ravenna and Walsh (2006), a wedge between the lending
rate and the policy rate disappears when  R  0 if an exogenous credit market shock is notpresent.
Inflation adjustment is depicted by the new Keynesian Phillips curve (NKPC), which plays animportant role in inflation dynamics. An open-economy NKPC expressed in terms of the real
marginal cost is given by H ,t  Et  H ,t 1  ˆt ,(37)

where   (1   )(1   ) /  and  H ,t is producer price inflation (PPI).
Substituting Eq. (32) into Eq. (37), an open-economy NKPC expressed in terms of the output
gap is derived as follows: H ,t  Et  H ,t 1   (     ) yt   yt*  Rˆ tL .

(38)

The dynamic IS curve, which is derived from the representative household’s Euler equation for
optimal consumption, is given byyt  Et yt 1   ( Et yt*1  yt* )   01 ( Rˆt  Et H ,t 1 )   t ,(39)

where  t represents the demand disturbance term. Also,






and  0  (1  ).

The set of variables under flexible price equilibrium is given as follows:Rˆ t f   0 ( Et Yˆt f1*  Yˆt f * )   0 ( Et Yˆt f1  Yˆt f ) ,(40)

Qˆ t f  (1   )ˆ t f   ( Et Qˆ t f1  Rˆ t f ) ,(41)

ˆ t f  Ŷt f ,(42)(     )Yˆt f  Yˆt f *  Rˆ t f  (1   )Z t .

(43)

Equation (40) represents the open-economy natural rate of interest that holds the real interest rate
under flexible price equilibrium. Eqs (41) and (42) are the stock prices and the dividends under
flexible price equilibrium. Eq. (43) describes the natural rate of output in an open economy model.
In contrast to the natural rate of output shown in Clarida, Gali and Gertler (2002), the natural rate ofoutput in the home country depends on the natural level of the lending rate.
13Under the case where both domestic and foreign households can trade Arrow–Debrew securities
both domestically and internationally, the following uncovered interest rate parity (UIP) holds:

Rˆ t  Rˆ t*  Et eˆt 1  eˆt .

(44)

To close the model, we now describe the monetary policy rules used in this study. This study
employs the standard monetary policy rule suggested by Taylor (1993). We specify a log-linearized
monetary policy rule as follows:Rˆ t    H ,t   y yt ,(45)

where  is the coefficient of the rate of inflation, and  y is the coefficient of the output gap. We
refer to this monetary policy rule as a benchmark rule. The next section compares the performance of
this rule with that under several alternative specifications of a monetary policy rule.

4. Calibration
This section describes the parameters used in this study. We set the degree of price rigidity 
to 0.75 based on Pappa (2004). Following previous studies in the new Keynesian literature, thediscount factor  is set to 0.99. Following Pappa (2004), we use a value of 2.0 for the risk
aversion coefficient,  . The elasticity of household labour supply  is set to 1.0. The elasticity of
substitution between domestic and foreign consumption goods a is set to 1.5. With regard to thedegree of openness, following Pappa (2004), we set  to 0.2. The elasticity of substitution for
individual goods is set to 5.0, based on the value calibrated in the existing literature.
Several studies report the value of the degree of financial market imperfection  R . Ravenna
and Walsh (2006) report that the value of the parameter  R is 0.276. Also, Chowdhury, Hoffman
and Schabert (2006) also estimate the value of financial market imperfection of 0.32 for the UnitedStates. Castelnuovo (2007) use the values  R  {0.5, 1.7} . 6 Therefore, we use the values R {0, 1.5} . In this paper, we focus on how the degree of financial market imperfections in theforeign country affects the home country. Therefore, the degree of financial market imperfections in
the home country is set to 0.276 based on the estimation value obtained in the study by Ravenna andWalsh (2006), whereas we set several values calibrated in above studies to that of the foreigncountries.
We now describe the parameters for the monetary policy rule. As a benchmark, we choose 1.5
and 0.5 for  and  y . Finally, with regard to the standard deviation of economic shocks, we
assume that   ,   , and  z are set to 0.01, respectively. Also, we assume that the parameters
Castelnuovo (2007) points out that a larger value of the parameter  R is likely to generate the price puzzle thatan increase in the policy rate increases inflation in the closed economy model.
614 ,   , and  z are set to 0.8, 0.8, and 0.8, respectively. Table 1 summarises the deepparameters calibrated in this study.

[Table 1 around here]

5. The role of financial market imperfections in a two-country economy
This section reports main simulation results obtained in the model. First, Section 5.1 provides
the results of the impulse response analysis. We explain that the impulse response function obtainedin the case of financial market imperfections in the foreign country differs from that in the case of nofinancial friction. In addition, we consider how the presence of a foreign financial friction influences
social welfare in the home country as the degree of openness increases. Second, Section 5.2 shows
how a change in financial market imperfections in the foreign country spills over to the homecountry. Finally, Section 5.3 shows how the home central bank should conduct its monetary policy inthe case where financial market imperfections are severe in the foreign country. Concretely, we
compare several alternative policy rules using the benchmark Taylor rule.

5.1. Benchmark results
Figure 1 displays the impulse response to a foreign positive productivity shock. The solid line
indicates the impulse response when financial market imperfections are absent in the foreign country.
The foreign productivity shock expands foreign output, but it reduces the foreign inflation rate.
Therefore, the foreign central bank cuts the policy rate down in accordance with a decline in the
inflation rate. On the other hand, after the foreign productivity shock, a decline in the home terms oftrade reduces home output, decreasing home inflation through a decline in the real marginal cost.
Accordingly, the home central bank implements a reduction of the policy rate, reducing the homelending rate. Consequently, the domestic stock price increases because a decline in the home lending
rate creates a boom in the home dividend.

[Figure 1 around here]

The above result is not applicable in the case of the presence of financial market imperfectionsin the foreign country. The line with an asterisk represents the impulse response when financial
market imperfections are present in the foreign country. A foreign productivity shock considerably
reduces both home inflation and output. Hence, the home central bank more aggressively cuts its
policy rate. Thus, the home central bank needs to conduct its monetary policy considering a foreign
15

financial friction.

[Figure 2 around here]

Figure 2 shows the impulse response when the lending rate exogenously increases in the foreigncountry. In the case of no financial friction in the foreign country, the foreign loan rate shock does
not impact the home country. On the other hand, when financial market imperfections are present,
the foreign loan rate shock generates a tradeoff between inflation and output in the foreign country.
In addition, the exogenous loan rate shock increases the foreign policy rate, resulting in a
depreciation of the real exchange rate in terms of home currency. Therefore, an improvement of thehome terms of trade increases both output and inflation in the home country. In other words, theforeign loan rate shock produces a boom in the home country. Home share prices also increase
through a rise in the home dividend derived from an upsurge in home output and a decline in foreign
output. Consequently, the home central bank raises its policy rate.
Summing up, the foreign productivity shock leads to a recession in the home country, whereas
the foreign loan rate shock creates a boom in the home country.
Figure 3 illustrates the impulse response to a foreign natural rate shock. Interestingly, theimpulse response when a foreign financial friction exists differs from that when a financial friction isabsent in the foreign country. First, in the case of no financial friction in the foreign country, theforeign natural rate shock worsens the home terms of trade, resulting in a decline in both inflationand output in the home country. Hence, the home central bank cuts its policy rate in response to arecession of the home country.

[Figure 3 around here]

On the other hand, when a financial friction is present in the foreign country, the foreign naturalrate shock can improve the home terms of trade. As a result, such an improvement of the homecountry’s terms of trade produces a boom in home output, increasing the home inflation rate. The
home central bank raises its policy rate in accordance with such responses of home country macro
variables. Compared with the case of no financial friction in the foreign country, the responses ofboth inflation and output are asymmetric when a financial friction exists in the foreign country.
The results obtained by the above impulse response analysis reveal that the presence offinancial market imperfections in the foreign country is never negligible. How then does the degreeof a foreign financial friction affect home social welfare? To answer this question, we calculate homesocial welfare. This paper assumes that the home loss function is given as follows:16

LH ,t  (1   ) E0   t ( H2 ,t  yt2 ) .

(46)

t 0

The parameter  represents the weight on the output gap relative to inflation stabilisation. As
explained in Walsh (2005), this criterion may lead to misguiding results. However, the reason that
we must employ the traditional loss function is as follows. In the two-country model, Clarida, Gali
and Gertler (2002) derive the central bank’s loss function in cases of both policy coordination and nopolicy coordination.
However, this paper has difficulty in assessing home social welfare using second-orderapproximation of the household’s utility function. Clarida, Gali and Gertler (2002) assume that the
optimal subsidies to make the steady state efficient in the case of policy coordination differ fromthose in the case of no policy coordination. In this paper, this difference is not crucial. The crucial
point is that the derivation of the loss function under policy coordination differs in that under nopolicy coordination. The welfare criterion under no policy coordination is related to the home loss
function. Such a criterion is derived under the presumption that the home country treats foreign
variables as given. However, this paper cannot assume that foreign variables are given. In contrast,
the worldwide loss function is derived under policy coordination, but such a criterion is not suitablefor our purpose. Hence, we use the traditional loss function to evaluate home social welfare.7 We
note that Equation (41) resembles the loss function derived under the assumption of no policy
coordination in Clarida, Gali, and Gertler (2002).

[Figure 4 around here]

Figure 4 shows the home welfare loss when the degrees of both foreign financial friction andopenness change.8 When the degree of openness is close to zero, a foreign financial friction neveraffects the home welfare loss. As the degree of openness increases, the presence of financial market
imperfections in the foreign country influences home social welfare. In particular, a predominately
higher value of the parameter  R worsens the home welfare loss as the degree of openness*

increases. As shown in Figures 1–3, compared with the case of no foreign financial friction, foreign
shocks generate a large fluctuation of home variables when financial market imperfections arepresent in the foreign country. The home central bank should respond aggressively to such a
response of home variables that are fluctuated by the presence of a foreign financial friction.
Therefore, the presence of foreign financial friction worsens home social welfare.

7

We might be able to strictly assess social welfare by solving a Ramsey policy. We would like to consider this issue
as a future work.
8 The parameter  is set to 0.25 based on the existing literature in the new Keynesian model.

175.2. The impact of foreign financial market imperfections on the home country
In Section 5.1, the presence of a foreign financial friction worsens home social welfare. This isbecause such a foreign financial friction amplifies foreign shocks, which generates a large
fluctuation of home country macro variables. More concretely, how do foreign structural shocks
affect home country macro variables as foreign financial friction becomes severe? In this section, we
examine how a change of a foreign financial friction leads to a fluctuation of home country macro
variables.
Figure 5 shows the impulse response to a foreign positive productivity shock under several
values of the parameter  R . For a larger value of  R , both home inflation and output drastically**decrease after the foreign productivity shock occurred. The home central bank should aggressively
cut its policy rate down in response to such a large drop in both inflation and output. In addition, theforeign country where the productivity shock occurred experiences a large drop in the inflation rate
and an increase in the output gap. Consequently, the foreign monetary authority also reduces thenominal interest rate.

[Figure 5 around here]

Figure 6 illustrates the impulse response to a foreign exogenous loan rate shock under several
values of the parameter  R . A larger value of  R amplifies the effect of the loan rate shock on**

the real economy. As shown in Figure 2, the foreign loan rate shock creates a tradeoff between
inflation and output in the foreign country. It follows from Figure 6 that such a tradeoff is more
severe as the parameter  R takes a larger value. On the other hand, for the home country, the*foreign loan rate shock improves the home terms of trade, inducing an appreciation of the realexchange rate. Accordingly, the home country experiences a boom in the output and an increase inhome inflation. Such a boom is accelerated by a larger value of the parameter  R .
*[Figure 6 around here]

These results are summarised as follows. In the case of no financial friction in the foreigncountry, the policy suggestion obtained in Clarida, Gali, and Gertler (2002) is applicable to ourmodel. However, the presence of a foreign financial friction changes the implication for monetary
policy derived in a two-country model. The transmission mechanism of foreign structural shocks
differs in the presence of a financial friction in the foreign country. In such a case, even if the homecountry does not face a severe financial friction, a severe financial friction in the foreign country
amplifies the impact of foreign shocks on the macro variables of the home country.
18

5.3. Monetary policy rules in a two-country economy with financial market imperfections

5.3.1. Alternative monetary policy rules
We now examine how the central bank should implement monetary policy in an economy withfinancial instability. This study considers three alternative policy rules: an output gap change rule, astock price rule and an exchange rate rule. The first rule is an output gap growth rule suggested byWalsh (2003). More specifically, we introduce an output gap change rule as follows:Rˆ t    H ,t   y yt   slp ( yt  yt 1 ) .

(47)

It follows from Eq. (42) that the central bank sets its policy rate in response to a change in the output
gap. Walsh (2003) shows that a gap change target can achieve preferable outcomes to a purediscretionary policy when the central bank cannot commit its monetary policy. This is because an
introduction of a gap change target in the monetary policy rule generates policy inertia. Therefore, ina forward-looking economy, the central bank can implement its monetary policy through the
management of private expectations (Woodford, 2003).
Next, we examine the performance of an asset price rule, which is given byRˆ t    H ,t   y yt  q (qt  qt 1 ) .

(48)

As suggested in De Giorgio and Nistico (2007) and Ida (2011), a monetary policy rule that
contains the stabilisation of asset prices might lead to preferable outcomes to a standard monetary
policy rule.9 Pfajfar and Santoro (2014) also argue that a stock price rule can produce preferable
outcomes when a strong cost channel is introduced into the economy.10
Finally, based on the idea of Taylor (2001), we also check the performance of a real exchange
rate rule. Specifically, this paper assumes that a real exchange rate rule is given as follows:Rˆt    H ,t   y yt  S (Sˆt  Sˆt 1 ) .

(49)

This regime might create a desirable outcome. The reason is that the central bank imparts policy
inertia through this rule because the real exchange rate is affected by a change of the terms of tradethat depends on home output.
Finally, this paper assumes that the home central bank employs these alternative policy rules,

9

Carstrom and Furest (2007) show that in the case of no cost channel, a policy rule that aimed at stabilising afluctuation of asset prices leads to equilibrium indeterminacy.
10 Ida (2011) findsthat a monetary policy rules that contains both domestic and foreign asset prices leads topreferable outcomes. However, he does not consider whether the degree of financial market imperfections in theforeign country affects the performance of an asset price rule.

19

whereas the foreign central bank conducts its monetary policy rule by following the standard Taylor
rule that contains the stabilisation of inflation and the output gap.

5.3.2. Performance of alternative policy rules
Table 1 calculates second moments of several home macro variables under several alternative
monetary policy rules.11 First, for a monetary policy rule that reacts to an asset price growth, it
produces the smallest variance of inflation. On the other hand, the stock price rule leads to thelargest variance of the output gap. This rule naturally achieves the smallest variance of stock prices.
Thus, a stock price rule can stabilize the inflation rate, whereas it generates the largest fluctuation of
the output gap. In sum, the home central bank that responds to asset prices faces a severe tradeoff
between inflation and the output gap.

[Table 2 around here]

Next, consider the performance of the output gap growth rule. Under this rule, the central bankcan attain the smallest variances of both inflation and the output gap. This rule also can avoid afluctuation of the real exchange rate. Intuitively, since a change of the output gap causes afluctuation of the home terms of trade, which changes the real exchange rate, a speed limit rule thatsmooths a change of the output gap can stabilise the real exchange rate.
Finally, we check the performance of a real exchange rate rule. This rule succeeds inreproducing the almost same results obtained from the speed limit rule. As we mentioned above, thisis because the real exchange rate rule can stabilise the output gap because the terms of trade througha change of home output affects the real exchange rate.

[Figure 7 around here][Figure 8 around here]

Figures 7 and 8 display the impulse response under several alternative rules. Figure 7 shows theimpulse response to the foreign positive productivity shock. It turns out that the result of the impulse
response analysis is consistent with that of Table 1. Though an asset price rule can stabilise afluctuation of both stock prices and inflation, it produces a larger fluctuation of the output gap. On
the other hand, a speed limit rule and a real exchange rate rule can stabilise inflation and the output
gap. Indeed, Table 3(i) reveals that the speed limit policy outperforms in that it succeeds instabilising both inflation and the output gap. Therefore, this result indicates that if structural shocks
11This paper assumes that slp  q  S  0.5 .

20are generated by a real factor, then it is desirable that the home central bank employs an output gap
change rule or a real exchange rate rule.
Figure 8 illustrates the impulse response to a foreign loan rate shock. In the case where
structural shocks are derived from a financial factor, if the home central bank sets its policy rate byfollowing an asset price rule, then it can restrain fluctuation of home macro variables. Hence, there
are gains from employing a stock price rule if structural shocks are related to financial factors.
Indeed, Table 3(ii) shows that for a foreign loan rate shock, an asset price rule can achievepreferable outcomes to alternative policy rules. There are two channels that a change in the lending
rate leads to a fluctuation of inflation. First, a fluctuation of the loan rate affects the real marginal
cost, changing the inflation rate. The second channel is that it affects share prices, which fluctuates
the inflation rate through dividend change. An asset price rule can completely stabilise the second
channel generated by financial shocks. Thus, it is possible that an asset price rule outperforms in thecase where the resource of structural shocks are associated with financial factors.

6. Concluding remarks
This study examined whether financial market imperfections matter in a two-country economy.
The result revealed that a cost channel associated with the presence of financial market
imperfections plays an important role in a two-country framework. In the case of no financial
friction in the foreign country, the implication obtained in a standard open economy model isapplicable to our model. However, the presence of a foreign financial friction changes theimplication for monetary policy derived in a standard two-country model. The transmission
mechanism of foreign structural shocks is quite different in the presence of a financial friction in theforeign country. In such a case, even if the home country does not face a severe financial friction, asevere financial friction in the foreign country amplifies the impact of foreign shocks on the homecountry macro variables.
This paper also addressed the effectiveness of an output gap growth rule in a two-country
economy with financial market imperfections. This rule can achieve the smaller variances ofinflation and the output gap. In particular, for a real shock, there are gains from employing this rule.
On the other hand, an asset price target rule can attain the smallest variance of inflation of all policy
regimes, whereas it produces the largest variances of the output gap. However, in the case of theforeign loan rate shock, an asset price rule can attain the preferable outcome. Thus, for a financial
shock, there might be gain from employing an asset price rule.
Finally, there are possible future extensions of the work in this study. We assumed that theexchange rate pass-through is perfectly complete. Thus, the law of one price holds in this model.
However, as argued in Corsetti and Pesenti (2001), Monacelli (2005) and Engel (2009), exchange
21

rate pass-through would be incomplete if firms set their export prices based on local currency pricing(LOP). It is interesting how financial market imperfection affects an open macroeconomic model inwhich incomplete exchange rate pass-through is present.
It is also worth investigating optimal monetary policy in a two-country economy with financial
market imperfections. It is interesting how optimal monetary policy changes when financial market
imperfections are present in a two-country economy. In particular, it is worth examining whether adomestic central bank coordinates a foreign central bank when financial market imperfections play asignificant role in both countries.

Acknowledgements
This paper was circulated as “Financial market imperfections in an open economy”. I would like tothank Kosuke Aoki, Kojiro Dohwa, Eiji Fujii, Kenji Fujiwara, Shigeto Kitano, Yutaka Kurihara,
Toshihiro Okada, Mitsuhiro Okano, Kenya Takaku and Yohei Tenryu for helpful comments andsuggestions. In addition, this study has been greatly improved by the helpful comments andsuggestions made by seminar participants at Keio University, Kwansei Gakuin University, Osaka
University, University of Kitakyusyu and University of Hyogo. All remaining errors are my own.

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23

Table 1: Baseline parameters

Parameter

Description

Value



Degree of price stickiness

0.75



Discount factor

0.99



Relative risk aversion coefficient

2.0




Elasticity of labor supply

1.0

Degree of openness

0.2

Elasticity of substitution

5.0

aElasticity of substitution between domestic and foreign goods

1.5



Coefficient for inflation stabilization

1.5

y

Coefficient for the stabilization of the output gap

0.5

v

Standard deviation of credit shock

0.01



Standard deviation of demand shock

0.01

z

Standard deviation of productivity shock

0.01

v

Auto-regression coefficient for credit shock

0.8



Auto-regression coefficient for demand shock

0.8

z

Auto-regression coefficient for productivity shock

0.8

24

Table 2: Second moment properties in the home country under alternative monetary policy rules(i)  R*  0.5
Inflation

Output gap

Asset prices

Real exchange rate

Benchmark

0.071

0.013

5.870

0.016

Output gap growth

0.069

0.008

5.794

0.011

Asset price growth

0.017

0.281

1.592

0.133

Real exchange rate growth

0.075

0.007

5.855

0.009

Inflation

Output gap

Asset prices

Real exchange rate

Benchmark

0.073

0.020

6.054

0.048

Output gap growth

0.072

0.011

5.924

0.040

Asset price growth

0.021

0.248

1.540

0.120

Real exchange rate growth

0.078

0.010

5.942

0.031

(ii)  R*  1.5

25

Table 3: Second moment properties of the home country under several alternative rules when

 R*  1.5(i)

Foreign productivity shock

Output gap

Inflation

Stock priceReal exchange
rate

Benchmark0.001929

0.000689

0.000392

0.01352

Speed limit rule0.0011290.000889

0.000204

0.011771

Asset price rule0.001633

0.000752

0.000104

0.012963

0.000696

0.000904

0.002581

0.008801

Real exchange rate
rule

(ii)

Foreign loan rate shock

Output gap

Inflation

Stock priceReal exchange
rate

Benchmark0.004259

0.000596

0.027709

0.018319

Spped limit rule0.002493

0.000883

0.016095

0.015338

Asset price rule0.0002560.000187

0.001168

0.002139

0.001692

0.001271

0.009114

0.012373

Real exchange rate
rule

26

Figure 1: Foreign positive productivity shock

Note: H denotes the impulse response of domestic variables. F represents the impulse response of foreign variables.

27

Figure 2: Foreign exogenous loan rate shock

Note: H denotes the impulse response of domestic variables. F represents the impulse response of foreign variables.

28

Figure 3: Foreign natural interest rate shock

Note: H denotes the impulse response of domestic variables. F represents the impulse response of foreign variables.

29

Figure 4: Home welfare loss when the parameters  R* and  change

30

Figure 5: Foreign positive productivity shock under several values of parameter  R*

Note: H denotes the impulse response of domestic variables. F represents the impulse response of foreign variables.

31

Figure6: Foreign exogenous loan rate shock under several values of parameter  R*

Note: H denotes the impulse response of domestic variables. F represents the impulse response of foreign variables.

32

Figure 7: The performance of alternative monetary policy rule: The case of foreign positive productivity shock

Note: H denotes the impulse response of domestic variables.

33

Figure 8: The performance of alternative monetary policy rules: The case of foreign exogenous loan rate shock

Note: H denotes the impulse response of domestic variables.

34