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Credit Frictions and Optimal Monetary Policy

78 Pages Posted: 30 Jul 2009  

Vasco Cúrdia

Federal Reserve Bank of San Francisco

Michael Woodford

Columbia University, Graduate School of Arts and Sciences, Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: March 1, 2009

Abstract

We extend the basic (representative-household) New Keynesian [NK] model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers, that can vary for either exogenous or endogenous reasons. We find that the mere existence of a positive average spread makes little quantitative difference for the predicted effects of particular policies. Variation in spreads over time is of greater significance, with consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation.

Nonetheless, we find that the target criterion - a linear relation that should be maintained between the inflation rate and changes in the output gap - that characterises optimal policy in the basic NK model continues to provide a good approximation to optimal policy, even in the presence of variations in credit spreads. We also consider a 'spread-adjusted Taylor rule,' in which the intercept of the Taylor rule is adjusted in proportion to changes in credit spreads. We show that while such an adjustment can improve upon an unadjusted Taylor rule, the optimal degree of adjustment is less than 100 percent; and even with the correct size of adjustment, such a rule of thumb remains inferior to the targeting rule.

This is part of a series of BIS Working Papers (273 to 278) collecting papers presented at the BIS's Seventh Annual Conference on "Whither monetary policy? Monetary policy challenges in the decade ahead" in Luzern, Switzerland, on 26-27 June 2008. The event brought together senior representatives of central banks and academic institutions to exchange views on this topic. BIS Paper 45 contains the opening address of William R. White (BIS), the contributions of the policy panel on 'Beyond price stability - the challenges ahead' and speeches by Edmund Phelps (Columbia University) and Martin Wolf (Financial Times). The participants in the policy panel discussion chaired by Malcolm D. Knight (BIS) were Martin Feldstein (Harvard University), Stanley Fischer (Bank of Israel), Mark Carney (Bank of Canada) and Jean-Pierre Landau (Banque de France). This Working Paper includes comments by Olivier Blanchard and Charles Goodhart.

Keywords: Financial Frictions, Interest Rate Spreads

JEL Classification: E43, E44

Suggested Citation

Cúrdia, Vasco and Woodford, Michael, Credit Frictions and Optimal Monetary Policy (March 1, 2009). BIS Working Paper No. 278. Available at SSRN: https://ssrn.com/abstract=1440289 or http://dx.doi.org/10.2139/ssrn.1440289

Vasco Cúrdia (Contact Author)

Federal Reserve Bank of San Francisco ( email )

101 Market Street
MS 1130
San Francisco, CA 94105
United States
(415) 977-3624 (Phone)

HOME PAGE: http://www.frbsf.org/economics/economists/staff.php?vcurdia

Michael Woodford

Columbia University, Graduate School of Arts and Sciences, Department of Economics ( email )

420 W. 118th Street
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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