Macroeconomic Policy Under Currency Mismatches in an Imperfect Financial Market

There is a large body of evidence documenting that many emerging market economies are subject to external financial shocks. We propose a two-country Dynamic General Equilibrium Model(DSGE) with three market imperfections: currency mismatches, moral hazard in banking and dominant currency pricing. Building upon Aoki, Benigno and Kiyotaki (2020) and Akinci, Queralto (2020), we analyze the optimal monetary policy in response to foreign interest rate shocks under the presence of the frictions. The results show that foreign monetary policy tightening leads to sharper local currency depreciation when import and export prices are set in the dominant currency compared to producer currency pricing. The optimal policy response to the foreign interest rate hike is a foreign exchange (FX) intervention with relatively strict inflation targeting. Macroprudential measures offer a modest macroeconomic and financial stabilization effect. We also conclude that domestically-produced goods inflation targeting alone is the worst monetary approach in EMs that attribute several real economy and financial imperfections. Nevertheless, allowing for integration of different monetary tools as well as introduction of FX hedging would be an interesting extension of our analysis.