Financial frictions and optimal stabilization policy in a monetary union

- We build a two-country DSGE-model of a monetary union with national cost channels.
- We show how national financial frictions affect the optimal stabilization policy.
- Financial frictions crucially change the monetary/fiscal policy assignment problem.
- The larger these frictions, the more important is fiscal policy for stabilization.
- Depending on financial friction, monetary policy could serve as supply-side policy.

Financial frictions differ across countries and thus cause international differences in the transmission of shocks. This paper shows how the optimal mix of monetary and fiscal policy depends on these country-specific financial frictions. To this end, we build a two-country DSGE-model of a monetary union. Financial frictions are captured by the cost channel approach. We show that the traditional solution to the assignment problem - the common central bank stabilizes the inflation rate at the union level and the national fiscal authorities stabilize the national economies - does not hold in a world with financial frictions. The cost channel decreases the efficiency of monetary policy and increases the need for fiscal stabilization even at the union level. Moreover, the more heterogeneous the union, the more important is fiscal policy in stabilizing shocks. Finally, we evaluate the scenarios in terms of welfare of the representative household.