Optimal Monetary Policy in a Model of the Credit Channel

52 Pages Posted: 24 Apr 2009

See all articles by Fiorella De Fiore

Fiorella De Fiore

Bank for International Settlements (BIS) - Monetary and Economic Department

Oreste Tristani

European Central Bank (ECB)

Date Written: April 24, 2009

Abstract

We consider a simple extension of the basic new-Keynesian setup in which we relax the assumption of frictionless financial markets. In our economy, asymmetric information and default risk lead banks to optimally charge a lending rate above the risk-free rate. Our contribution is threefold. First, we derive analytically the loglinearised equations which characterise aggregate dynamics in our model and show that they nest those of the new-Keynesian model. A key difference is that marginal costs increase not only with the output gap, but also with the credit spread and the nominal interest rate. Second, we find that financial market imperfections imply that exogenous disturbances, including technology shocks, generate a trade-off between output and inflation stabilisation. Third, we show that, in our model, an aggressive easing of policy is optimal in response to adverse financial market shocks.

Keywords: optimal monetary policy, financial markets, asymmetric information

JEL Classification: E52, E44

Suggested Citation

De Fiore, Fiorella and Tristani, Oreste, Optimal Monetary Policy in a Model of the Credit Channel (April 24, 2009). ECB Working Paper No. 1043, Available at SSRN: https://ssrn.com/abstract=1383502 or http://dx.doi.org/10.2139/ssrn.1383502

Fiorella De Fiore

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Oreste Tristani (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
0049 69 13440 (Phone)
0049 69 1344 6000 (Fax)

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