Credit Market Distortions, Asset Prices and Monetary Policy
CentER Discussion Paper Series No. 2012-010
28 Pages Posted: 2 Feb 2012
Date Written: February 1, 2012
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: Suggested Citation