Monetary Policy and the Financing of Firms
Fiorella De Fiore
European Central Bank (ECB) - Directorate General Research
Federal Reserve Bank of Chicago; Centre for Economic Policy Research (CEPR)
European Central Bank (ECB)
CEPR Discussion Paper No. DP7419
How should monetary policy respond to changes in financial conditions? In this paper we consider a simple model where firms are subject to idyosincratic shocks which may force them to default on their debt. Firms' assets and liabilities are denominated in nominal terms and predetermined when shocks occur. Monetary policy can therefore affect the real value of funds used to finance production. Furthermore, policy affects the loan and deposit rates. We find that maintaining price stability at all times is not optimal; that the optimal response to adverse financial shocks is to lower interest rates, if not at the zero bound, and engineer a short period of inflation; that the Taylor rule may implement allocations that have opposite cyclical properties to the optimal ones.
Number of Pages in PDF File: 37
Keywords: bankruptcy costs, debt deflation, Financial stability, optimal monetary policy, price level volatility, stabilization policy
JEL Classification: E20, E44, E52working papers series
Date posted: September 8, 2009
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