Foreign financial shocks and domestic credit policy in the small open economy

This paper introduces a global banking system in a small open economy DSGE model and features global relative price adjustments with incomplete asset market to investigate the role of international financial imperfections. We show that credit policy could be more powerful than monetary policy to alleviate foreign financial shocks since an expansionary monetary policy and alternative policy rules are not a sufficient tool in the global financial crisis. In particular, credit policy based on international credit spread outperforms credit policy based on domestic credit spread since the former attempts to remove distortions from international financial imperfections and reduces real costs of foreign loans. Accordingly, the lower costs of external finance further boost investment and effectively stabilize the economy without substantial asset purchases.