Optimal Monetary Policy under Asset MarketSegmentation1Amartya Lahi riUniversity of British ColumbiaRajesh SinghIowa State UniversityCarl os VeghUniversity of Maryland and NBERPreliminary and incomplete draft: September 20071The authors would like to thank V.V. Chari, Marty Eichenbaum, Andy Neumeyer, Graham Ross, andseminar participants at Duke, Iowa State, IDB, and UBC’s New Issues in International Financial Marketsconference for helpful comments and suggestions on previous versions. The us ual disclaimer applies.AbstractThis paper studies optimal monetary policy in a small open economy under ‡exible prices. Thepaper’s key innovation is to analyze this question in the context of environments where only afraction of agents participate in asset market transactions (i.e., asset markets are se gmented). Inthis environment, we study three rules: the optimal state contingent monetary policy; the optimalnon-state contingent money growth rule; and the optimal non-state contingent devaluation raterule. We compare welfare and the volatility of macro aggegates like consumption, exchange rate,and money under the di¤erent rules. One of our key …ndings is that amongst non -state contingentrules, policies targeting the exchange rate are, in general, welfare dominated by policies that allowfor some exchange rate ‡exibility. Crucially, we …nd that …xed exchange rates are almost neveroptimal. On the other hand, under some conditions, a non-state contingent rule like a …xed moneyrule can even implement the …rst-best allo cation.Keywords: Optimal monetary policy, asset market segmentationJEL Classification: F1, F21 IntroductionThe desirability of alternative monetary policies continues to be one of the most analyzed and hotlydebated issues in macroeconomics. If anything, the issue is even of greater relevance for emergingmarkets, which experience far greater macroeconomic volatility than industrial countries. Shouldemerging markets …x the exchange rate to a strong currency or should they let it ‡oat? Sh ouldthey be targeting in‡ation and follow Taylor-typ e rules or should they have a monetary target? Inpractice, the range of experiences is not only broad but also varies c onside rably over time. Whilein the early 1990s many emerging countries were following some sort of exchange rate peg (the10-year Argentinean currency b oard that started in 1991 being the most prominent example), mostof them switched to more ‡exible arrangements after the 1994 Mexican crisis and the 1997-98Asian crises. If history is any guide, however, countries dislike large ‡uc tuations in exchange ratesand eventually seek to limit them by interventions or interest rates changes (Calvo and Reinhart(2002)). Hence, it would not be surprising to see a return to less ‡exible arrangements in the nearfuture. The cross-country and time variation of monetary policy and exch ange rate arrangements inemerging countries is thus remarkable and essentially captures the di¤erent views of policymakersand international …nancial institutions regarding the p ros and cons of di¤erent regimes.The conventional wisdom derived from the literature regarding the choice of exchange rateregimes is based on the Mundell-Fleming model (i.e., a small open economy with sticky pricesand perfect capital mobility). In such a model, it can be shown (see Calvo (1999) for a simplederivation) that if the policymaker’s objective is to minimize output variability, …xed exchangerates are optimal if mon etary shocks dominate and ‡exible exchange rates are optimal if realshocks dominate. As Calvo (1999, p. 4) puts it, this is “a result that every well-trained economistcarries on [his/her] tongue”. Th e intuition is simple enough: real shocks require an adjustment inrelative prices which, in the presence of sticky prices, can most easily be e¤ected through changesin the nominal exchange rate; in contrast, monetary shocks require an adjustment in real moneybalances that can be most easily carried out through changes in nominal money balances (which1happens endogenously under …xed exchange rates). In fact, most of the modern literature on thechoice of exchange rate regimes has considered variations of the Mundell-Fleming model in modernclothes (rechristened nowadays as “new open economy macroeconomics”): for instance, Engel andDevereux (1998) show how the conventional results are sensitive to whether prices are denominatedin the produce r’s or consumer’s currency and Cespedes, Chang, and Velasco (2000) incorporateliability dollarization and balance sheets e¤ects and conclude that the standard prescription infavor of ‡exible exchange rates in respons e to real shocks is not essentially a¤ected. In a similarvein, while the literature on monetary policy rules for open economies is more recent, it has beencarried out mostly in the context of sticky-prices model (see, for instance, Clarida, Gali, and Gertler(2001), Ghironi and Rebucci (2001), and Scmitt-Grohe and Uribe (2000)). In particular, Clarida,Gali, and Gertler (2001) conclude that Taylor-type rules remain optimal in an open economy thoughopenness can a¤ect the quantitative magnitude of the responses involved.The fact that most of the literature on the choice of exchange rate regimes and monetary policyrules relies on sticky prices models raises a fundamental (though seldom asked) question: are stickyprices (i.e., frictions in good markets) more relevant in emerging markets than frictions in assetmarkets? Given that even for the United States 59 percent of the population (as of 1989) did nothold interest bearing assets (see Mulligan and Sala-i-Martin (2000)) and that, for all the …nancialopening of recent decades, …nancial markets in developing countries remain far less sophisticatedthan in the United States, it stands to reason clear that …nancial markets frictions are pervasivein developing countries. In this light, it would seem important to understand the implications ofmodels with …nancial markets frictions for the optimal choice of exchange rate regimes and policyrules. A convenient way of modelling …nancial market frictions is to assume that, at any pointin time, some agents do not have access to asset markets (due to, say, a …xed cost of entry, lackof information, and so forth). This so-called asset market segmentation models have been usedwidely in the closed macro literature (see, among others, Alvarez and Atkeson (1997), Alvarez,Lucas,