Monopolistic Banks, Fixed Retail Rates, and Housing: Policy Implications for Open Economy Inflation Targeting

WORK IN PROGRESS We investigate the implications of several key features of mortgage markets for optimal policy for open economy inflation targeters. We show that the existence of fixed mortgage contracts shifts the transmission of monetary policy away from the standard interest rate transmission channel towards direct and indirect exchange rate channels. In addition, contracts that allow for higher loan-to-value ratios and duration allow greater consumption smoothing. To quantify the impact of these effects on open economy inflation targeting, we calibrate our DSGE model to the case of New Zealand and solve for optimal time-consistent policy. New Zealand is the earliest explicit inflation targeter and proves a useful test case since many of the institutional features of mortgage markets are shared with other countries and the strength of the global boom in housing has been at least as strong as other countries. We show that optimal time-consistent policy shifts towards responding more aggressively to inflation and that particular policy reforms would reduce volatility in the economy. Jaroḿır Beneš, International Monetary Fund (IMF) 700 19th Street, N.W. Washington, DC 20431 United States E-mail: [email protected]. Kirdan Lees, Economics Department, Reserve Bank of New Zealand, 2 The Terrace, Wellington, 6011, New Zealand & C.A.M.A.. E-mail: [email protected].