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Title: Country Portfolios, Collateral Constraints and Optimal Monetary Policy

Author(s): Ozge Senay and Alan Sutherland

Publication Date: September 2016

Keyword(s): Collateral constraints, Country portfolios, Financial market structure and Optimal monetary policy

Programme Area(s): International Macroeconomics and Finance

Abstract: Recent literature shows that, when international financial trade is absent, optimal policy deviates significantly from strict inflation targeting, but when there is trade in equities and bonds, optimal policy is close to strict inflation targeting. A separate line of literature shows that collateral constraints can imply that cross-border portfolio holdings act as a shock transmission mechanism which significantly undermines risk sharing. This raises an important question: does asset trade in the presence of collateral constraints imply a greater role for monetary policy as a risk sharing device? This paper finds that the combination of asset trade with collateral constraints does imply a potentially large welfare gain from optimal policy (relative to inflation targeting). However, the welfare gain of optimal policy is even larger when there is no international asset trade (but collateral constraints bind within each country). In other words, the risk sharing role of asset trade tends to reduce the welfare gains from policy optimisation even when collateral constraints act as a shock transmission mechanism. This is true even when there are large and persistent collateral constraint shocks.

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Bibliographic Reference

Senay, O and Sutherland, A. 2016. 'Country Portfolios, Collateral Constraints and Optimal Monetary Policy'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11499