Central Bank Macroeconomic Modeling Workshop Jerusalem, 28-29 October 2009

1. Central Bank Macroeconomic Modeling WorkshopJerusalem, 28-29 October 2009 Discussion on Financial Shocks and Optimal Monetary Policy in Small Open Economies by Caputo, Medina, Soto (2009) Central Bank of Chile Diana Shtylla Gent Hashorva Bank of Albania

2. Contents • Highlights and main findings of the paper • Assessing monetary policy reaction in Albania • Concluding comments

3. The premises of the paper • To analyze optimal monetary policy response to financial shocks in a small open economy • Previous studies: in a closed economy a financial shock has only contractive impact and there is no monetary policy trade-off. • Question posed by authors: what is the policy trade-off in a small open economy facing a financial shock? • Model: extension of the Medina and Soto (2008) DSGE model to account for (i) imperfect exchange rate pass-through to import price inflation and (ii) financial friction in the form of an exogenous spread between the market and the policy rate.

4. The main conclusions • Findings: optimal policy response depends on: • (i) the degree of correlation between the shock and foreign financial conditions; • (ii) the extent to which UIP holds with the policy rate or the market interest rate. • Policy trade-off is highest when domestic financial shock is perfectly correlated with foreign financial conditions (risk premia) and UIP holds with the policy rate • No evidence of a policy trade-off when domestic shock not correlated with external conditions and UIP holds w/ mkt rate • If UIP holds w/ mkt rate, trade-off is smaller than otherwise • Trade-off disappears completely when CB is not concerned with policy rate volatility. • Results are robust to different CB preferences – different values of ωi.

5. Assessing monetary policy in Albania • Small open and highly dollarized economy, with increasing dependence of domestic financial developments on foreign financial conditions. • Confidence shock (Q4 2008) was reflected in high liquidity premium and financial shock • Low FX inflows, withdrawals of deposits, credit deceleration • Risk premia increased and exchange rate depreciated • However, inflation remained low and inflation expectations stayed within the BoA 3%+/-1pp target

6. Albania – inflation

7. Albania – annual credit growth

8. Albania – lending rates

9. Albania – nominal exchange rates

10. Albania – base policy rate

11. Inflation and exchange rate in SEE countries

12. Albania - monetary policy reaction Which of the examined cases applies to Albania? • High correlation to foreign financial conditions. • BoA is concerned about policy instrument volatility. • BoA seems aware of the trade-off between inflation and output • BoA places higher importance to inflation in line with its legal mandate. • Similarly to other CEE countries (Hungary and Romania), conservative monetary policy prioritized a stable exchange rate as a tool of preserving price and financial stability

13. Comments about the paper • Very important and relevant for similar research by other small open economies operating under free – float exchange rate regime. • Model is clearly presented and well-explained. • Conclusions can be improved by including some of the findings in the robustness exercise. • The model uses ρi=0.7 (from Berenstein and Fuentes 2004). During financial crises, the value of the coefficient could change, implying a more complicated task for the central bank. Especially when UIP holds with the policy rate, the shift in ρi might increase the policy trade-off. Authors could consider a range of values and the associated implications for the policy trade-off.

14. Thank you!