Financial Frictions in the Small Open Economy

This paper introduces a global banking system in a small open economy DSGE model with financial frictions. The model features global relative price adjustments with incomplete asset market. Three main findings stand out. Firstly, foreign financial shocks capture negative spillovers from foreign country in a global financial crisis. We show that country differences in the severity of the shocks depend on the degree of trade openness and banking system stability. Secondly, credit policy could be more powerful than monetary policy to alleviate foreign financial shocks since an expansionary monetary policy and alternative policy rules are not a sufficient tool in the global financial crisis. In particular, credit policy based on international credit spread outperforms credit policy based on domestic credit spread since the latter leads to “excess smoothness” in the real exchange rate. Lastly, foreign credit policy has a negligible influence on domestic welfare so that the small open economy can effectively reduce welfare losses only if the central bank in the economy injects credit.