Financial Markets
Monetary Shocks

Recent research has extended Lucas's work on the liquidity effects of open market operations to an open economy and to allow for non-neutrality of monetary injections in a closed economy. In Discussion Paper No. 566, Research Fellows Vittorio Grilli and Nouriel Roubini develop an open economy model in which the determination of output is endogenous to analyse the effects of monetary policy on real activity, and in particular the role of credit institutions in transmitting monetary shocks to the domestic real economy and the rest of the world. They distinguish the discount rate of the central bank and the interest rates faced by lenders and borrowers from the commercial banking system and consider the latter's reserve requirements. They also consider the means by which monetary policy is transmitted, distinguishing between injections through nominal lump-sum transfers from government to individuals and those deriving from an increase in central bank credit to commercial banks through discount window operations. They assume that the latter will be sterilized via a lump-sum transfer and will therefore not affect monetary growth.

They find that injections of liquidity into the banking system have asymmetric effects on firms' and consumers' decisions and are associated with a temporary segmentation between assets and goods markets. Taken together, these imply that output expansions are associated with real exchange rate depreciations, so the main results of the Mundell-Fleming model remain valid even with perfectly flexible prices. The order of causality is reversed from the standard sticky-price model, however, since in this case monetary shocks lead to output expansions that worsen the domestic terms of trade. Moreover, the output expansions associated with these monetary injections do not necessarily increase welfare. The authors find, however, that direct monetary transfers to households lead to increases in monetary growth that are associated with higher inflation and interest rates, output contractions and real exchange rate appreciations.

Grilli and Roubini then consider two models of the international transmission of these monetary shocks. Where only labour and domestic investment (intermediate) goods are used in (domestic) production, increases in domestic credit affect domestic but not foreign output, although foreign consumption and welfare are affected through the effect of the monetary shock on the terms of trade.Where domestic firms use both domestic and foreign investment goods, however, domestic monetary shocks exert similar effects on domestic and foreign output, so there is a positive international transmission of monetary disturbances.

Financial Intermediation and Monetary Policies in the World Economy
Vittorio Grilli and Nouriel Roubini

Discussion Paper No. 566, July 1991 (IM)