Exchange rate dynamics and monetary spillovers with imperfect financial markets

Akinci, Ozge; Queraltó, Albert

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Exchange rate dynamics and monetary spillovers with imperfect financial markets

Abstract: We use a two-country New Keynesian model with financial frictions and dollar debt in balance sheets to investigate the foreign effects of U.S. monetary policy. Financial amplification works through an endogenous deviation from uncovered interest parity (UIP) arising from limits to arbitrage in private intermediation. Combined with dollar trade invoicing, this mechanism leads to large spillovers from U.S. policy, consistent with the evidence. Foreign monetary policies that attempt to stabilize the exchange rate reduce welfare and may exacerbate exchange rate volatility. We document empirically a link between UIP deviations and measures of credit market frictions, as predicted by the model.

Keywords: financial frictions; U.S. monetary policy spillovers; currency premium; uncovered interest rate parity condition;

JEL Classification: E32; E44; F41;