Lithuania in the Euro Area: Monetary Transmission and Macroprudential Policies

This article develops a two-country monetary union new Keynesian general equilibrium model with housing and collateral constraints calibrated for Lithuania and the rest of the euro area. Within this setting, and following the recent entry of Lithuania in the European Monetary Union, the aim of the article is twofold. First, it studies how shocks are transmitted differently in the two regions, considering the recent common monetary policy. It then analyzes how Lithuanian macroprudential policies should be conducted in the context of the EMU. The proposed macroprudential tool is a decentralized Taylor-type rule for the LTV which responds to national deviations in output and house prices. Given the features of Lithuania's housing market, common shocks are found to be transmitted more strongly in this country than in the rest of the euro area. In terms of macroprudential policies, results show that the optimal policy in Lithuania with respect to the euro area may have a different intensity and that it delivers substantial benefits in terms of financial stability.