Optimal Monetary Policy with Uncertainty about Financial Frictions
De Nederlandsche Bank
ECB Working Paper No. 639
This paper studies optimal discretionary monetary policy in the presence of uncertainty about the degree of financial frictions. Changes in the degree of financial frictions are modelled as changes in parameters of a hybrid New-Keynesian model calibrated for the UK, following Bean, Larsen and Nikolov (2002). Uncertainty about the degree of financial frictions is modelled as Markov switching between regimes without and with strong financial frictions. Optimal monetary policy is determined for different scenarios of permanent and temporary regime shifts in financial frictions, as well as for variations in financial frictions over the business cycle. Optimal monetary policy is found to be state-dependent. In each state, optimal monetary policy depends on the transition probabilities between the different regimes.
Number of Pages in PDF File: 34
Keywords: Monetary policy, uncertainty, financial frictions
JEL Classification: E52, E58, E61, E44working papers series
Date posted: June 30, 2006
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