Credit frictions, fiscal imbalances, monetary policy autonomy, and monetary policy rules

Abstract

The current study mathematically derives the monetary policy reaction function (MPRF) by incorporating credit spreads, fiscal imbalances, and monetary policy autonomy. The policy reaction function (PRF) has been derived in the framework of Dynamic Stochastic General Equilibrium (DSGE) model. The model clearly states that capital controls allow the central authorities to focus on the stability of domestic prices instead of worrying about capital outflows. The results of the calibrated model predict that credit spread, fiscal imbalances, and monetary policy autonomy significantly affect the rate of interest. The estimates suggest that most of the variability in output, inflation, and the interest rate occurs due to supply and credit spread shocks.