Credit Market Distortions, Asset Prices and Monetary Policy

European Banking Center Discussion Paper No. 2012-005

CentER Discussion Paper Series No. 2012-010

28 Pages Posted: 2 Feb 2012

See all articles by Damjan Pfajfar

Damjan Pfajfar

Board of Governors of the Federal Reserve System

Emiliano Santoro

Catholic University of the Sacred Heart of Milan - Department of Economics

Date Written: February 1, 2012

Abstract

We study the conditions that ensure rational expectations equilibrium (REE) determinacy and expectational stability (E-stability) in a standard sticky-price model augmented with the cost channel. We allow for varying degrees of pass-through of the policy rate to bank-lending rates. Strong cost-side effects heavily constrain the policy rate response to inflation from above, so that inflation targeting policies may not be capable of ensuring REE uniqueness. In such cases, it is advisable to combine inflation responses with an appropriate reaction to the output gap and/or firm profitability. The negative reaction of real activity and asset prices to inflationary shocks adds a negative force to inflation responses that counteracts the borrowing cost effect and avoids expectations of higher inflation to become self-fulfilling.

Keywords: monetary policy, cost channel, asset prices, determinacy, e-stability

JEL Classification: E31, E32, E52

Suggested Citation

Pfajfar, Damjan and Santoro, Emiliano, Credit Market Distortions, Asset Prices and Monetary Policy (February 1, 2012). European Banking Center Discussion Paper No. 2012-005. Available at SSRN: https://ssrn.com/abstract=1997057 or http://dx.doi.org/10.2139/ssrn.1997057

Damjan Pfajfar (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Emiliano Santoro

Catholic University of the Sacred Heart of Milan - Department of Economics ( email )

20123 Milano
Italy

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