DP6147 | Financial Globalization and Monetary Policy

Publication Date

23/02/2007

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Abstract

The process of financial globalization has significantly altered the environment in which national monetary policy authorities operate. What implications does this have for the design of monetary policy? The question can be properly addressed only in the context of a model where monetary policy interacts with financial market efficiency. This paper is concerned with the effects of monetary policy when international portfolio choice is endogenous. We analyze the link between monetary policy and gross national bond and equity portfolios. With endogenous portfolio structure and incomplete markets, monetary policy takes on new importance due to its impact on the distribution of returns on nominal assets. Despite this, we find that the case for price stability as an optimal monetary rule still remains. In fact, it is reinforced. Even without nominal price rigidities, price stability has a welfare benefit through its enhancement of the risk sharing properties of nominal bond returns.