Monetary Policy and Financial Sustainability in a Two-State Open Economy

Abstract

Monetary policy and financial sustainability are linked. However, the role of monetary policy and its implementation have come under particular scrutiny after the 2008 Global Financial Crisis (GFC) and the 2010 European sovereign debt crisis, where one of the main challenges was financial sustainability. In this paper, we contribute to the literature by improving our understanding of the influence of monetary policy on financial sustainability for a monetary union. To that end, we develop a two-state open economy macroeconomic model, in which the two state economies have the same monetary policy but maintain their fiscal independence. Examples include two countries in the eurozone, two states in the United States, core and periphery countries, etc. The linkages between these two state economies are inter-state trade in goods and inter-state borrowing in bonds. We apply the calibrated model and conduct economic experiments under alternative monetary policy regimes. The model simulation shows that monetary policy is incorrect if inflation differentials persist in a monetary union, and that incorrect monetary policy leads to real interest rates that are too low for high inflation countries, which become indebted after excessive borrowing. This study sheds light on how monetary policy should be implemented if inflation differs in countries within a monetary union. Our findings draw policy implications for those “two-state” economies considering alternative macroeconomic policy regimes to achieve financial sustainability and regional economic integration.